White Paper Examines Confusion Surrounding Risk Parity Products
Used by Many Investors
Risk parity has gained popularity in the investment community in recent years. However, as the report notes, some of the properties of the approach and its utilization are often misunderstood. The paper addresses key misperceptions, such as: risk parity as a strategic asset allocation (SAA) strategy versus hedge fund strategy, conditions under which risk parity is actually optimal, the use of risk balancing, and leverage and accommodation for tactical (or “current”) views.
“Despite the prevalence of risk parity allocations in portfolios and the increase in risk parity products available to investors, there are still many misperceptions about its theoretical justifications and role within the portfolio,” said
The report discusses the importance of correlations, not just the Sharpe Ratios (risk-adjusted returns), to achieving an optimality in a risk parity portfolio, and how the return and risk requirements of other approaches have impacted investors’ adoption of risk parity. In practice, people have moved away from classic mean-variance optimization, which requires error-free return and risk estimates, and toward approaches such as risk parity without a complete understanding of why or how the two techniques relate to each other. The paper explains how risk parity actually serves as a “practical cousin” of 1950s Markowitz mean-variance optimization, incorporating core concepts such as risk balancing and leverage, rather than being a departure from the traditional investment theory.
“Although theoretically inferior to mean-variance optimization, risk parity is a reasonable ‘starting point’ for investors’ public market, strategic asset allocation because of estimation error,” commented Mr. Hecht. “It’s very difficult to estimate expected returns with any precision, and because risk parity requires no expected return estimates, I think of it as a practical implementation of mean-variance optimization.”
According to the report, some in the investment community have condemned risk parity in the current interest rate environment. Illustrating a lack of understanding about the properties and underlying assumptions of strategic asset allocation solutions, many have criticized risk parity’s large dollar allocations to assets like fixed income. SAA approaches, however, by definition do not account for tactical views, such as an unfavorable interest rate environment. Actual asset allocation weights must be reweighted to reflect tactical views. This is not an exclusive property to risk parity; however, it is a common misunderstanding among investors.
“Risk parity has large dollar allocations to fixed income, which in the current low interest rate environment has led to criticism of risk parity portfolios,” said
“Investors should be informed about how their assets are allocated, why certain approaches are being implemented and how the approaches are applied to benefit their overall portfolio,” said