Understanding Risk Parity: Strategies and Real-World Examples

What Is Risk Parity?

Risk parity is a portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio. This method stems from modern portfolio theory (MPT) but enhances it by focusing on risk-weighted allocations, allowing investors to target specific risk levels.

The approach is favored by sophisticated investors and hedge funds due to its complex quantitative calculations, which lead to a more refined portfolio composition compared to traditional allocation methods. Real world applications of risk parity include funds like the AQR Risk Parity Fund and Horizon's Global Risk Parity ETF, which demonstrate how the strategy can be applied across various markets and asset types.

How Risk Parity Works in Investment Portfolios

Risk parity is an advanced portfolio technique often used by hedge funds and sophisticated investors. It requires a complex quantitative methodology, which makes its allocations more advanced than simplified allocation strategies.

The goal of risk parity investing is to earn the optimal level of return at the targeted risk level.

Simplified allocation strategies such as the 60%/40% stocks-bonds portfolio make use of MPT. MPT provides a standard for diversification within one's investment portfolio that maximizes expected return for a given level of risk. In simplified MPT strategies using just stocks and bonds, allocations are usually more heavily weighted toward equities for investors who wish to take on more risk. Risk-averse investors will instead have a higher weight in bonds for capital preservation.

Risk parity strategies include leverage, alternative diversification, and short selling in portfolios and funds. In this approach, managers can choose any mix of assets. Instead of distributing allocations to achieve a risk target, they use the desired risk level as the foundation for investing. This goal is often achieved by using leverage to weight risk equally among different asset classes using the optimal risk target level.

Exploring Key Strategies of Risk Parity

With a risk parity strategy, an investment portfolio will often include stocks and bonds. However, instead of using a predetermined proportion of asset diversification such as 60/40, the investment class proportions are determined by a targeted risk and return level. Risk parity strategies have generally evolved and developed from MPT investing. They allow investors to target specific levels of risk and to divide risk across the entire investment portfolio to achieve optimized portfolio diversification.

The security market line (SML) is another part of the risk parity approach. The SML is a graphical representation of the relationship between the risk and return of an asset and is used in the capital asset pricing model (CAPM). The slope of the line is determined by the beta of the market. The line slopes upward. The greater the possibility for the return of an asset, the higher the risk associated with that asset.

There is a built-in assumption that the slope of the SML is constant. The constant slope assumption, however, may not actually be realistic. For the traditional 60/40 allocation, investors must take greater risk to achieve acceptable returns, and the diversification benefits are limited as more and riskier equities are added to the portfolio. Risk parity solves this issue by using leverage to equalize the amount of volatility and risk across the different assets in the portfolio.

Real-Life Applications of Risk Parity Strategies

The AQR Risk Parity Fund invests globally across stocks, bonds, currencies, and commodities and seeks to achieve optimal return through balanced risk parity investing.

Horizon's Global Risk Parity ETF also uses a risk parity strategy in its investments. The exchange traded fund (ETF) employs an equal risk-weighted volatility distribution to determine the amount of capital participation.