Investors are increasingly looking at new ways to diversify their portfolios in an attempt to mitigate risk. One technique that has garnered attention of late is risk parity. Martin Dietz, Multi-Asset Fund Manager at Legal & General Investment Management (LGIM), answers some common questions.
What is risk parity?
Risk parity is an approach for asset allocation that focuses squarely on the efficient allocation of portfolio risk. The proposition is to move away from thinking about portfolios in terms of their capital weights and to emphasise their risk weights and exposures instead. To do that, a risk parity investor identifies the key risk factors or risk drivers of a portfolio and then allocates equal risk budgets to all of them. Risk parity portfolios tend to use leverage to scale low-risk assets, such as bonds, to the same stand-alone risk level as other asset classes (such as equities).
The risk parity approach doesn’t formally incorporate return expectations, but argues that returns naturally follow on from the structural exposure to market risks. This is in contrast to traditional mean-variance optimisation, which uses explicit risk and return estimates and formally optimises the allocation to achieve maximum expected return for a given risk budget.
Risk parity improves on some known issues with the classic mean-variance approach to portfolio construction. In particular, the traditional optimisation turns out to be very sensitive to the return estimates and often suggests very concentrated allocations – in other words, large weights in just a few asset classes.
Risk parity resolves this problem by using risk estimates only. Another issue with mean-variance models is their focus on simplistic risk models. These simplifications are still made in a standard risk parity approach.
Why is it a popular alternative to other asset allocation techniques?
Risk parity has established and emphasised a focus on risk (rather than capital) weights, putting diversification and non-equity return drivers at the centre of the investment process. The need for diversification is now widely accepted and should therefore be an essential consideration for every multi-asset product.
A key selling point for risk parity is that it provides an easy-to-understand and intuitive narrative to explain its investment approach, one that puts the risk and diversification focus at the core. The most powerful marketing feature of risk parity investors has been to emphasise the excessive exposure to equity risk in many institutional portfolios and balanced funds.
Risk parity portfolios, by construction, appear balanced when looked at through the risk factor lens. A further reason for risk parity’s popularity is its performance during the credit crisis.
During this period, low exposure to equities and high exposure to bonds managed to reduce the drawdowns significantly. Since then, investors have found that risk parity funds perform relatively well, as most risky assets appreciated.
However, the strategy suffered from losses in mid-2013 (as bond markets sold off) and as part of the recent commodity and emerging market weakness.