Abstract: In the past several weeks, risk parity funds such as Bridgewater’s All Weather have attracted substantial criticism. The attacks have clustered around two primary notions: firstly, that risk parity is a failure because it did not protect investors during August’s drawdowns and secondly, that risk parity may have caused or at least amplified the market’s sudden losses. In this post, we’ll evaluate the legitimacy of these two claims, as well as provide a deeper understanding of the motivations and behaviors of risk parity funds.
Defining Risk Parity
Most investor portfolios are heavily weighted towards equity risk. A typical 60/40 portfolio, for example, will usually derive 80-90% of its risk from equities since stocks are much more volatile that bonds.
Risk parity is an asset allocation methodology that strives to overcome this problem by creating portfolios that distribute risk roughly equally between assets. There are several ways to do this, but the most common approach is to weight assets by the inverse of their volatility. Doing so increases weights on low volatility assets and decreases weights on high volatility assets so that each asset’s levered or de-levered position has an identical expected volatility.
Most risk parity funds then lever this volatility weighted portfolio to target a specific level of risk. In Bridgewater’s case, this is a 12% annualized standard deviation. The result is a portfolio that has similar total risk to a 60/40 portfolio, but a much more equitable internal distribution of risks.
Risk Parity is a Simple, but Imperfect Solution to a Complicated Problem
The idea behind risk parity is a good one. It results in meaningfully more diversified portfolios. Risk parity is not a perfect strategy, however. It has plenty of faults, including: