Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, sets the framework for building optimal portfolios in which market participants can potentially maximize portfolio returns for a given level of risk. The theory introduces the notion of portfolio diversification by holding non-correlated assets. At the core, one should not view individual asset returns and volatilities in isolation; rather, one should take into account the co-movements, or correlations, of asset returns that comprise a portfolio.
The theory, along with the expectation that long-term asset class Sharpe ratios are similar (Dalio et al. 2015), act as foundational pieces of risk parity. Risk parity strategies propose that portfolio diversification, defined as achieving the highest return per unit of risk, can be maximized when a portfolio’s assets contribute equally to total portfolio risk.
Since the launch of the first risk parity fund—Bridgewater’s All Weather Fund—in 1996, many asset managers have offered their version of risk parity to clients. The risk parity industry has especially gained traction in the aftermath of the 2008 global financial crisis, growing to an estimated USD 150 billion-175 billion at year-end 2017 according to the IMF (Antoshin et al. 2018).