Consistent with misapprehensions expressed during other recent market crises, there has been a chorus of alarmist speculation about the actions and state of risk-parity strategies during the current crash. We felt it would be helpful to revisit the concept of risk parity and take a snapshot of how a typical global risk parity strategy might have been expected to behave this year.
As a quick refresher, risk parity is a global asset allocation strategy that emphasizes preparedness over prediction. The idea is to prioritize DIVERSITY and BALANCE:
- Diversity is about holding markets that are fundamentally designed to flourish in different market environments, and growth opportunities around the world
- Balance is about ensuring that markets with different risk characteristics are able to contribute equally to the portfolio
As an asset allocation model, risk parity strategies focus on market exposures with long-term expected positive returns: global stocks, bonds, and commodities. The primary drivers of returns to these markets are unexpected changes to expectations about growth and inflation. Different asset classes would be expected to respond in predictable ways to shifts in these dynamics.
Figure 1. Asset class expected responses to inflation and growth regimes.
Source: ReSolve Asset Management. For illustrative purposes only.
Critically, when constructing portfolios for risk parity the emphasis is on preparation rather than prediction. The strategy is designed to express the view that it is almost impossible to accurately and consistently estimate the future state of markets and the economy. The difficulty in foresight means that we are equally likely to rely on stocks, bonds and/or commodities for returns in the future. From a risk parity standpoint, major global asset classes all have the same expected return when adjusted for their respective risks.
Extreme diversification makes it common for risk parity strategies to exhibit naturally low levels of volatility. To achieve higher return targets, investors may use leverage to increase their exposure to the entire portfolio. Among the most popular risk parity funds, it is most common to scale portfolios to target an 8 percent to 10 percent annualized standard deviation.