Risk Parity is Not Short Volatility (Not That There's Anything Wrong with Short Volatility)

Abstract

There have been increasingly frequent claims that risk parity strategies are hiding an implicit short volatility exposure or behave as though they are short volatility. In order to test the veracity of these claims, we simulate stylized versions of three-asset-class (equity, fixed income, and commodities) risk parity and short volatility strategies, and we compare the trading behavior and returns of each. We conclude that the two strategies’ similarities are overstated, and we find no empirical evidence to support the claimed hidden exposure. Even with conservative assumptions designed to heighten the similarity of the two strategies, their trades are uncorrelated (or even slightly negative correlated) at almost any horizon. Though their returns are moderately correlated, the correlation is explained by common exposure to equities and bonds, not by common exposure to gamma or other forms of convexity. Controlling for these static underlying exposures, we find that the returns of the two strategies are almost orthogonal, with short volatility explaining less than one percent of the total variance of risk parity returns. We extend our analysis to consider equity and fixed income asset classes in isolation, where we observe very similar results.