Risk Parity: The Concept

September 12, 2013

“Risk parity” — the concept of achieving diversification by sources of risk — is gaining wider attention.

  • Investors are typically counseled to diversify capital across asset classes in order to reduce risk. 
  • In light of this, it may be something of a surprise to learn just how concentrated the risk sources of a traditionally diversified portfolio may be.
  • “Risk parity”—the concept of achieving diversification by sources of risk—is gaining wider attention.
  • While there are numerous risks involved with investing, “risk,” as we refer to it in this paper, means volatility or standard deviation; it does not specifically encompass other sources of investment risk.

“Risk parity” is an investment strategy that seeks to balance the sources of risk in a portfolio. The easiest way to envision this concept may be to consider it in the context of a traditional, diversified portfolio. For many investors, this portfolio is represented by defined percentage allocations across stocks and bonds. Such a balanced portfolio, for example, will often allocate 50% of its assets to stocks and 50% to bonds in an effort to achieve diversification. However, research indicates that this equal allocation of investment capital does not necessarily equate to being diversified by risk.

This is because stocks tend to exhibit four-to-five times more volatility than bonds. So, while the weighting of a balanced portfolio appears to be even and equal, the investment in equities carries significantly greater risk than the investment in bonds. Exhibit 1 highlights the disparity.

Exhibit 1: Balanced Portfolio Allocations

exhibit 1 balanced portfolio allocations

 

 

 

 

Risk Parity: Balanced Risk

Risk parity investment strategies seek to diversify sources of risk. Each source of risk carries a risk premium, which is a potential source of return. In order to achieve this diversification, these strategies assume that asset classes (such as stocks and bonds) should contribute equally to the level of risk in a portfolio. For example, based on volatility over the past 20 years, a portfolio would only need to allocate 19% to U.S. stocks and 81% to U.S. bonds to make the contributions to risk equal, as seen in Exhibit 2.

exhibit 2 balanced risk

 

 

 

 

 

Risk Parity—Beyond the Basics

At the simplest level, a risk parity portfolio seeks to achieve equal contributions to risk across various asset classes. In addition, risk parity strategies tend to allocate beyond stocks and bonds in an effort to provide upside growth and downside mitigation through various economic scenarios, as shown in Exhibit 3 on the following page.

Exhibit 3: Exposures for Varying Economic Regimes

exhibit 3 exposures for varying economic regimes

 

 

 

 

 

For example, a hypothetical risk parity strategy may include global stocks in addition to domestic stocks for growth-oriented environments, and include inflation-sensitive assets (i.e., commodities) for inflationary environments. These assets are not always accounted for in less-diversified portfolios.

Once the asset-class allocations are established, some managers maintain equal contribution to risk by monitoring a short-term level of volatility of each asset-class bucket and actively rebalancing the portfolio’s exposure based on rising or falling volatility. When the volatility of an asset rises, its contribution to risk is maintained by reducing its allocation to the portfolio. If all assets experience an increase in volatility (as in the 2008 credit crisis), exposures across each bucket will be reduced and the assets shifted to cash.

Potential Benefits

Proponents of risk parity believe that a balanced risk allocation can produce higher and more consistent returns than a traditional capital-allocated portfolio over time. The benefits of the strategy include reduced allocations to and reliance on the stock market generally, a more diversified set of exposures during varying economic scenarios, and the potential for enhanced risk/return characteristics.

No investment strategy is without risk. Seeking to allocate assets in a way that keeps one asset class from dominating performance can be beneficial for risk-management purposes.

No investment strategy is without risk. Seeking to allocate assets in a way that keeps one asset class from dominating performance can be beneficial for risk-management purposes. However, compared to a traditional portfolio, broad diversification beyond stocks and bonds can lead to performance differences. Reduced exposures to more volatile, and potentially higher returning, asset classes can result in lower volatility—but also lower returns.

Risk parity strategies can be structured to target higher risk (and return) profiles while balancing risks across asset classes. In these instances, the strategy will apply a form of leverage (which involves its own set of investment risks) to lower volatility assets (such as bonds) to better equate their risks (and return) with other, higher returning asset classes. However, many managers seek to mitigate these risks by using highly liquid securities and other instruments.

Global Indexes and investing terminology

Legal Note

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This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.

There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results.

Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company.