Leif Mizer 
Risk parity differs from traditional portfolio optimization strategies in that it focuses more on risk levels per asset class, creating more balanced portfolios that can withstand different economic scenarios more easily.
Historically, these strategies have produced superior returns compared to points on the efficient frontier such as a 60/40 mix of stocks and bonds. However, recent implied leverage and volatility targets have caused large variations among funds that implement this strategy.
Alternative Investments
Risk parity strategies aim to diversify sources of portfolio risk through equal risk contribution – allocating investment capital so as to balance out any individual asset’s contribution towards matching a given risk budget.
Traditional portfolio allocations focus on stocks and bonds, yet these two asset classes exhibit differing historical volatility characteristics. Equities historically have been three times more volatile than bonds; therefore an allocation that evens out equity volatility with bond volatility would likely be driven more heavily by equity volatility than by any potential bond effects.
That means the diversification benefits of bonds may become obscured, while correlation and volatility projections based on historical data could make the allocation less resilient to future economic scenarios.
Equities
Risk parity, also known as leveraged bonds, involves budgeting portfolio risks with redistribution and leveraging. It serves as an alternative approach to traditional mean variance portfolio optimization with typically a mix of assets as its foundation.
Risk-parity funds have long been associated with Bridgewater Associates LP and its founder Ray Dalio as well as AQR Capital Management LLC, but most risk-parity funds struggled during 2022.
As stocks are much riskier than bonds (sometimes up to three times more in terms of volatility), their performance determines most multi-asset class portfolio returns. To counteract this effect, risk-parity strategies use low-returning asset classes with significant leverage as part of their portfolios.
Bonds
Bridgewater Associates popularized risk parity strategies that use lower-risk investments such as bonds to mitigate higher-risk investments such as stocks. Their allocation strategy allocates investment dollars based on each asset class’s volatility and an investor’s risk appetite.
This strategy seeks to outstrip traditional 60/40 allocations by minimizing both expected portfolio risk and return, and taking advantage of lower correlations among asset classes.
Under rising-rate environments, however, risk-parity allocations may no longer work as effectively because movements between stocks and bonds no longer cancel each other out – this is particularly evident among inflation-hedging assets such as TIPS or commodities.
Real Estate
Risk parity requires regular rebalancing, or selling underperforming assets and purchasing overperforming ones to maintain equal weights across portfolios. Rebalancing may become increasingly challenging during periods of market stress when asset prices may move in different directions.
Risk parity differs from traditional balanced stock/bond portfolios in that it takes into account additional measures of risk to accurately evaluate each asset class’s true risk, such as skewness and fat tails. By considering these variables, risk parity portfolios can expand beyond stocks and bonds to include commodities, real estate investments and alternative investments.
But rising rates and inflation can nullify the diversification benefits of risk parity strategies by increasing correlation between bond prices and equity markets.
Money Markets
Risk parity strategies aim to allocate their assets evenly among asset classes in order to balance out their contribution to overall portfolio risk. Leverage may be used in these strategies in order to achieve this objective.
This approach involves intricate mathematical calculations and is typically considered more advanced than simpler allocation strategies. Hedge funds and sophisticated investors often utilize this strategy.
Risk-parity managers aim to outdo their 60/40 counterparts by achieving higher risk-adjusted returns than unlevered, lower-yielding asset classes. They do this by diversifying among low-volatility assets like bonds with equity, currency and commodities investments.
Fixed Income
Risk parity is an advanced method for diversifying portfolios that seeks to evenly balance risk across investments at an optimal risk level.
Since equities tend to be two to three times riskier than bonds, the performance of an asset allocation equally divided between stocks and bonds will largely depend on equity risk. To counteract this imbalance, risk parity strategies employ leverage in order to equalize bond exposures by equalizing their risks contributions.
Rising rates or an inverted yield curve can have detrimental impacts on risk-parity fund returns. Due to estimation errors and variance in projections used for risk management algorithms, results for risk parity funds in 2018 have shown great variation.
