Investor Views, Risk Parity, and Hedge Fund Portfolio Construction

Abstract

Risk Parity has recently become one of the most frequently used portfolio construction frameworks within the institutional investor community. It would probably become even more popular if not for explicitly disregarding investor views on asset valuations, which sometimes leads to Risk Parity producing counter-intuitive results. In what follows we re-formulate the Risk Parity approach in a way that allows for incorporating investor views. The key change that we suggest is to switch from volatility as a principal measure of asset risk within the Risk Parity framework to expected drawdown. As we will demonstrate, such change makes incorporating investor views into the Risk Parity framework possible and intuitive, which in our 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.