Investor Views, Drawdown-Based Risk Parity, and Hedge Fund Portfolio Construction

Abstract

Recently, risk parity has become one of the most frequently used portfolio construction frameworks within the institutional investor community. It would probably become even more popular if it didn’t explicitly disregard investor views on asset valuations, which sometimes leads to risk parity producing counterintuitive results. In this article, the authors reformulate the risk parity approach in a way that allows for incorporating investor views. The key change that they suggest is to switch from volatility as a principal measure of asset risk within the risk parity framework to expected drawdown. As the authors demonstrate, such a change makes incorporating investor views into the risk parity framework possible and intuitive, which, in their opinion, represents a welcome enhancement to an already widely used technique. A range of potential applications in the arena of both traditional and alternative investments is discussed.