A Novel Approach to Risk Parity: Diversification across Risk Factors and Market Regimes

Abstract

In this article, the authors describe a robust approach to portfolio diversification that balances risk contributions across risk factors and market regimes. After identifying four compensated macro risk factors—growth, inflation, real rates, and liquidity—the authors construct a factor portfolio for each based on a broad set of asset classes, including proxies for private equity and private real estate. Next, the authors identify five distinct market regimes characterized by unique asset class behaviors. The factor portfolios are then combined such that the risk contributions to the resulting total portfolio are as balanced as possible, regardless of which market regime materializes. By combining regime-aware correlations with dynamic volatility estimates for each factor and applying standard 1.5× to 2× leverage, the authors demonstrate a risk-parity portfolio with 10% ex ante volatility and attractive absolute and risk-adjusted returns. Compared with a traditional 60/40 portfolio, the proposed risk-parity portfolio displays greater diversification, more consistent factor-risk contributions, and greater resilience to economic shocks.