The Long and the Short of Risk Parity

Abstract

The author investigates the application of risk parity (RP) to three types of systematic long–short investment strategies commonly used by practitioners: trend following, pairs trading, and factor investing. Although RP tends to improve risk-adjusted returns before transaction costs are considered, it increases portfolio turnover relative to simpler portfolio construction methods, such as equally weighted (EW) and naive risk parity (NRP) approaches. Whether an RP overlay can improve the after-cost, risk-adjusted performance of a long–short strategy depends strongly on the transaction costs involved and the level of correlation among the components of the strategy. Among the three long–short strategies studied, only trend following seems to reliably benefit from RP, especially when the correlations among the trends are higher, as in recent periods. Pairs trading, which is a high-turnover strategy with many largely uncorrelated bets, performs better with a simple EW approach. In factor investing, RP delivers risk-adjusted returns similar to an EW or NRP combination of 10 factors.