The Long and the Short of Risk Parity

Abstract

I investigate 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. While 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 a 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 similar risk-adjusted returns to an EW or NRP combination of ten factors.