Risk Parity Funds Have Failed to Work as Advertised

In times like these, when nothing seems to work in financial markets, risk parity strategies should act as a sort of shock absorber. It’s a simple concept, really. Unless you have reason to believe one investment is better than another, you should take equal risk in each. That gives you maximum diversification, and diversification is still the only free lunch in finance.

Risk parity gained popularity in the 2008 crash, but interest gradually waned in the following years when the stock market went only up. Diversification has gotten cool again since the onset of the pandemic as a mitigant to an uncertain and volatile world. But these funds haven’t always managed to work as advertised, leaving investors, especially the nonprofessionals, with unexpected losses.

While risk parity has been interpreted in a variety of ways, the practical definition for asset managers today is a fund that tries to take equal volatility in stocks, bonds and commodities, with a target overall volatility that is most commonly 10% per year. This is approximately the volatility of a conventional portfolio invested 60% in stocks and 40% in bonds. But because stocks are more volatile than bonds, 60/40 took 82% of its risk in stocks over the last 10 years so got only limited diversification benefit from bonds, and none from commodities. In theory, and in empirical data going back many decades, risk parity should deliver consistently better returns with the same volatility as 60/40.

However, in the last 10 years, taking excessive risk in stocks has been a winning move. Stocks averaged 10.9% per year, bonds negative 0.9% and commodities negative 0.4%. As a result, the risk-parity index has returned only 6.0% with 10.8% realized volatility, compared with 6.3% with 10.1% volatility for a 60/40 portfolio.