The principles behind risk parity relate to answering a deceptively straightforward question: What is diversification? Traditionally, investors have allocated their capital among multiple asset classes to achieve diversification, such as the 60/40 equity/bond blend. Such an approach leads to a disproportionate allocation of risk across asset classes, with equities taking up most of the risk allocation.
A risk parity strategy aims for balanced risk contribution from all asset classes. We understand that asset class returns are generally proportional to the risk taken (according to the Capital Market Pricing Model) and that a diversified portfolio consisting of relatively uncorrelated assets may reduce risk without foregoing return. Different economic cycles also expose different asset classes to different levels of risk. Risk parity strategies take these factors into account and aim to balance risk contribution from a mix of assets and apply leverage to the overall portfolio, which can help to meet the twin challenges of achieving higher returns, while reducing risk in a diversified portfolio.
Since the first risk parity fund—Bridgewater’s All Weather fund—premiered in 1996, many investment companies have begun offering risk parity funds to their clients, especially in the aftermath of the global financial crisis in 2008. Such strategies lacked an appropriate benchmark, and most investors used a traditional 60/40 mix to benchmark the returns of risk parity funds. The issue that can arise from this is that most of these benchmarks do not reflect either the construction or the risk/return expectations from such strategies. In addition, risk parity strategies have been largely in the domain of active management, even though these strategies are systematic and lend themselves well to passive implementation.