Risk parity

Risk parity (or risk premia parity) is an approach to investment management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital. The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio can achieve a higher Sharpe ratio and can be more resistant to market downturns than the traditional portfolio. Risk parity is vulnerable to significant shifts in correlation regimes, such as observed in Q1 2020, which led to the significant underperformance of risk-parity funds in the Covid-19 sell-off.[citation needed]

Roughly speaking, the approach of building a risk parity portfolio is similar to creating a minimum-variance portfolio subject to the constraint that each asset (or asset class, such as bonds, stocks, real estate, etc.) contributes equally to the portfolio overall volatility.[1][2]

Some of its theoretical components were developed in the 1950s and 1960s but the first risk parity fund, called the All Weather fund, was pioneered in 1996. In recent years many investment companies have begun offering risk parity funds to their clients. The term, risk parity, came into use in 2005, coined by Edward Qian, of PanAgora Asset Management, and was then adopted by the asset management industry. Risk parity can be seen as either a passive or active management strategy.[3]

Interest in the risk parity approach has increased since the 2007–2008 financial crisis as the risk parity approach fared better than traditionally constructed portfolios, as well as many hedge funds.[4][5] Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions[6][7] but others point to its performance during the 2007–2008 financial crisis as an indication of its potential success.[8][9]

  1. ^ Sébastien Maillard, Thierry Roncalli, Jérôme Teiletche. "On the properties of equally-weighted risk contributions portfolios" (PDF). Archived (PDF) from the original on 2016-02-22. Retrieved 2016-06-07.{{cite web}}: CS1 maint: multiple names: authors list (link)
  2. ^ "Risk Parity portfolio construction". quant.stackexchange.com. Archived from the original on 2016-06-25. Retrieved 2016-06-07.
  3. ^ Cite error: The named reference Qian1 was invoked but never defined (see the help page).
  4. ^ Cite error: The named reference IPE was invoked but never defined (see the help page).
  5. ^ Cite error: The named reference IPE April 2011 was invoked but never defined (see the help page).
  6. ^ Cite error: The named reference Missed Op was invoked but never defined (see the help page).
  7. ^ Anderson, Robert M.; Bianchi, Stephen W.; Goldberg, Lisa R. (November–December 2012). "Will My Risk Parity Strategy Outperform?". Financial Analysts Journal. 68 (6): 75–93. doi:10.2469/faj.v68.n6.7. Archived from the original on 2020-06-27. Retrieved 2019-07-01.
  8. ^ Cite error: The named reference Choueifaty was invoked but never defined (see the help page).
  9. ^ Cite error: The named reference Martellini was invoked but never defined (see the help page).