Efficient Markets: Why Risk Parity Works Part 1
The explanation for why risk parity works reside in two parallel theoretical frameworks for investment. The first is modern portfolio theory that connects investment strategy to the public markets. The second is behavioral economics, which connects the strategy deployed to the universe of investment managers. These frameworks provide the rationale for risk management because risk and return vary through time. The traditional rationale for risk parity is intuitively appealing.
Loss Aversion: The Core of Risk Parity
The objective of risk parity is managing risk. A portfolio contains three principal drivers of risk: public markets, strategy, and uncorrelated return (“alpha”). The differentiation between the three is critical to portfolio management. Public market beta is exposure to traditional assets, including equities and bonds. For US investors, typical indices that measure these returns profiles are the S&P 500 index for US large-capitalization stocks and the FTSE Broad Investment Gr
Risk Parity: Managed Diversity
The strategic rationale for an asset class is whether it improves portfolio efficiency (i.e., the ratio of return-to-risk). The intransigent nature of expected returns and the measurable benefits of diversification implies that the risk component is more amenable to management. This statement does not suggest the irrelevance of the new asset class returns. An asset class's addition to the portfolio must achieve either a similar expected return at lower risk or a higher return
Risk Parity: Asset Classes versus Risk Factors
Traditional asset allocation varies the asset class weights when optimizing the portfolio for efficiency. A problem arises from this methodology because each asset class can possess exposure to other risk factors. Equities may have commodity and currency exposure, while corporate bonds can contain interest rate and equity factors. Disentangling the factor exposures requires robust statistical analysis. More important is whether this increased complexity matters. The answer is