Risk parity
[citation needed] Roughly speaking, the approach of building a risk parity portfolio is similar to creating a minimum-variance portfolio subject to the constraint that each asset (or asset class, such as bonds, stocks, real estate, etc.)
In recent years many investment companies have begun offering risk parity funds to their clients.
[4][5] Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions[6][7] but others point to its performance during the 2007–2008 financial crisis as an indication of its potential success.
[10][11] The risk parity approach attempts to equalize risk by allocating funds to a wider range of categories such as stocks, government bonds, credit-related securities and inflation hedges (including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial leveraging.
[14] Some scholars contend that a risk parity portfolio requires strong management and continuous oversight to reduce the potential for negative consequences as a result of leverage and allocation building in the form of buying and selling of assets to keep dollar holdings at predetermined and equalized risk levels.
[15] On the other hand, some consider risk parity to be a passive approach, because it does not require the portfolio manager to buy or sell securities on the basis of judgments about future market behavior.
or equivalently This problem has a unique solution which can be determined with provably convergent convex optimization methods [18] .
[24] The seeds for the risk parity approach were sown when economist and Nobel Prize winner, Harry Markowitz introduced the concept of the efficient frontier into modern portfolio theory in 1952.
[16] The theoretical analysis of combining leverage and minimizing risk amongst multiple assets in a portfolio was also examined by Jack Treynor in 1961, William F. Sharpe in 1964, John Lintner in 1965 and Jan Mossin in 1966.
However, the concept was not put into practice due to the difficulties of implementing leverage in the portfolio of a large institution.
[25] According to Joe Flaherty, senior vice president at MFS Investment Management, "the idea of risk parity goes back to the 1990s".
In 1996, Bridgewater Associates launched a risk parity fund called the All Weather asset allocation strategy.
[4][14][26][27] Although Bridgewater Associates was the first to bring a risk parity product to market, they did not coin the term.
Instead the term "risk parity" was first used by Edward Qian, of PanAgora Asset Management, when he authored a white paper in 2005.
[41] According to a 2010 article in the Wall Street Journal "Risk-parity funds held up relatively well during the financial crisis" of 2008.
[43] However, mutual funds using the risk parity strategy were reported to have incurred losses of 6.75% during the first half of the year.
[44] With the bullish stock market of the 1990s, equity-heavy investing approaches outperformed risk parity in the near term.
[45] However, after the March 2000 crash, there was an increased interest in risk parity, first among institutional investors in the United States and then in Europe.
[4][5] USA investors include the Wisconsin State Investment Board and the Pennsylvania Public School Employees’ Retirement System (PSERS) which have invested hundreds of millions in the risk parity funds of AQR, BlackRock and Bridgewater Associates.
[46][47][48][3][49] The 2007–2008 financial crisis was also hard on equity-heavy and Yale Model portfolios,[50] but risk parity funds fared reasonably well.
[8][9][51][52] Despite criticisms from skeptics, the risk parity approach has seen a "flurry of activity" following a decade of "subpar equity performance".
[53] During the period 2005 to 2012 several companies began offering risk parity products including: Barclays Global Investors (now BlackRock), Schroders, First Quadrant, Mellon Capital Management, Neuberger Berman and State Street Global Advisors.
[54] A 2011 survey of institutional investors and consultants suggests that over 50% of America-based benefit pension and endowments and foundations are currently using, or considering, risk parity products for their investment portfolios.
[6] Other critics warn that the use of leverage and relying heavily on fixed income assets may create its own risk.
[58][59][60] Inker also says that risk parity requires too much leverage to produce the same expected returns as conventional alternatives.
Proponents answer that the reduced risk from additional diversification more than offsets the additional leverage risk and that leverage through publicly traded futures and prime brokerage financing of assets also means a high percentage of cash in the portfolio to cover losses and margin calls.
Proponents have countered by saying that their approach calls for reduced exposure to bonds as volatility increases and provides less skew than conventional portfolios.
[62] A 2012 article in the Financial Times indicated possible challenges for risk parity funds "at the peak of a 30-year bull market for fixed income".
While advocates point out their diversification amongst bonds as well as "inflation-linked securities, corporate credit, emerging market debt, commodities and equities, balanced by how each asset class responds to two factors: changes in the expected rate of economic growth and changes to expectations for inflation".
One specific set of assumptions that puts the risk parity portfolio on the efficient frontier is that the individual asset classes are uncorrelated and have identical Sharpe ratios.
