The Risk Parity Approach to Asset Allocation - Climbing the Wall of Worries?

Abstract:     
The risk parity asset allocation methodology has recently increased in popularity, as such strategies have in general avoided the hefty drawdowns during the recent volatile market periods. Even the most fervent critics appreciate the diversifying potential historically provided by risk parity concepts. However, they point out that the tide may be turning. It is often stated that the past merits of the strategy may be its future challenges. Concerns raised relate to issues like: While being of inestimable value during the subprime crisis, isn’t it overly risky to be considerably exposed to government bonds in light of uncomfortably high sovereign debt? Having successfully exploited dynamic correlation relationships in the past, can the concept still provide a diversified portfolio even with the virtual outage of fixed income instruments as a source of return because of record low yields? In spite of facilitating the equalisation of risk contributions, does the leverage usually employed not expose the portfolio to heightened tail risks? The responses brought forward to these legitimate criticisms, are as diverse as the group of discussants is numerous. The objective of this note is, therefore, to contribute to the discussion by taking a general point of view. What can be inferred from empirical evidence in order to judge the future attractiveness of the risk parity concept relative to alternative asset allocation strategies in general? And how does the concept compare with respect to the specific concerns highlighted above? In order to answer these questions, we contrast three different yet popular allocation styles, namely a traditional balanced strategy, the minimum variance concept and the risk parity methodology. The results suggest that while the current criticism has its warrants, empirical evidence points towards the expectation that risk parity strategies may further climb up the wall of worries.

Number of Pages in PDF File: 7

Keywords: Asset Allocation, Portfolio Construction, Risk Parity, Minimum Variance

JEL Classification: G10, G11, G15

working papers series