Risk Parity Research Summary, May 2012

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We analyze 3 papers in the “risk parity” series:

  • “Leverage Aversion and Risk Parity” by Asness, Frazinni, and Pederson (2012)
  • “Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios” by Chaves, Hsu, Li, and Shakernia (2011)
  • “On the properties of equally-weighted risk contributions portfolios” by Maillard, Roncalli, and Teiletche (2010)
  • Our primary focus is on a paper by Asness, Frazzini, and Pederson (Leverage Aversion and Risk Parity) in 2012, which offers the most practical and straight forward analysis of risk parity.

The following quote from Asness, Frazzini, and Pederson quickly summarizes the idea behind risk parity.

“Risk Parity investing starts from the observation that traditional asset allocations, such as the market portfolio or the 60/40 portfolio in U.S. stocks/bonds, are insufficiently diversified when viewed from the perspective of how each investment contributes to the risk of the overall portfolio. Because stocks are so much more volatile than bonds, movement in the stock market dominates the risk in a 60/40 portfolio. Thus, when viewed from a risk perspective, 60/40 is mainly an equity portfolio since nearly all of the variation in the performance is explained by variation in equity markets. In this sense, 60/40 offers little diversification even though 60/40 looks well balanced when viewed from the perspective of dollars invested in each asset class.”
–“Leverage Aversion and Risk Parity” by Asness, Frazinni, and Pederson (2012)

  • We end this report by highlighting research that is critical of the risk parity approach.
  • Our conclusion on risk parity as an asset allocation system is mixed. On one hand, the backtested results are solid. However, one must use significant amounts of leverage, it is unclear what the benchmark is when assessing risk parity portfolios, and there are open questions as to whether slight perturbations in estimation techniques affect results. In a future research report we will address these research questions—as well as others–in detail.

We have created a risk parity for dummies to help readers understand the mechanics behind a risk parity portfolio.

Team Mission: To empower investors through education.