The Flawed Critique of Risk Parity Strategies

Risk parity strategies have been gaining attention in the financial industry, but they've also faced criticism from some quarters. At First Quadrant, we've taken a closer look at these criticisms and found that many are based on misunderstandings or oversimplifications.

That said, let's examine what risk parity is all about. It's a strategy that balances risk across asset classes rather than capital. This approach adds a third dimension to traditional asset allocation, which only considers expected return vs. risk through mean-variance optimization.

The Misconceptions Surrounding Risk Parity

One common criticism of risk parity is that it relies too heavily on leverage, which can be risky in itself. However, we've mitigated these risks by limiting leverage through exchange-traded futures where counter-party and liquidity risks are minimized.

In fact, leveraging bonds is a typical outcome of a risk parity optimization, but this introduces a significant inflation risk into the portfolio. As such, an inflation hedging component is necessary, such as commodities and inflation-protected bonds like TIPS.

The Proper Way to Implement Risk Parity

To properly implement risk parity, it's essential to recognize that not all assets should be leveraged, even if they're low-risk assets. Corporate bonds, for instance, have undesirable characteristics when leveraged, particularly tied to counter-party risk and liquidity constraints during market declines.

We've developed a rule that any asset with internal leverage (like stocks and corporate bonds) shouldn't be leveraged again externally. Instead, sovereign bonds can be easily leveraged in the futures markets where there are no counter-party risks or liquidity issues.

The Asset Allocation Implications

When implementing risk parity, it's crucial to consider the implications for portfolio allocation. In a risk parity portfolio, sovereign bonds should be the primary focus for leveraging due to their low-risk profile and ability to be easily leveraged in futures markets.

Commodities are not expected to produce a positive excess return over the long run; they hedge the portfolio against inflation risk. A full risk parity allocation to commodities is not desirable.

Putting Risk Parity into Practice

To get the most out of risk parity, investors should focus on creating a diversified portfolio that balances risk across asset classes. This means leveraging sovereign bonds while minimizing risks associated with other assets like corporate bonds and commodities.

By following these guidelines, investors can create a more efficient strategic portfolio that minimizes volatility drag and maximizes returns.

A Risk Parity Roadmap

In conclusion, the criticisms of risk parity strategies are often based on misunderstandings or oversimplifications. By understanding the proper way to implement risk parity and considering the implications for portfolio allocation, investors can create a more efficient strategic portfolio that balances risk across asset classes.