Are Risk-Parity Managers at Risk Parity?

Abstract

Risk parity has become an accepted investment strategy, to some degree. Its main advantage is its use of risk allocation, as opposed to the capital allocation used by the traditional asset allocation approach. A balanced risk allocation provides true diversification; therefore risk parity should deliver better risk-adjusted return over time. Despite the acceptance and the fact that the term “risk parity” has been in use for almost ten years, the investment community seems confused about risk parity’s true definition. Is it just a quantitative risk-budgeting technique? Is it about operational leverage? Or is it about high exposures to fixed income and low exposures to equities? In this paper, the author aims to define the principle of risk parity investing. He then examines a sample of risk parity managers, using the return-based style analysis pioneered by William Sharpe. The results show that, according to the defined principle, a number of risk parity managers in our sample are not using true risk parity. <b>TOPICS:</b>Portfolio management/multi-asset allocation, factors, risk premia, risk management