The Risk in Risk Parity: A Factor Based Analysis of Asset Based Risk Parity

Abstract:     
The risks embedded in asset-based risk parity portfolios are explored using a simple, economically motivated factor approach. We show that such an approach can substantially demystify and make explicit the drivers of returns for asset-based risk parity portfolios. The proposed framework can be used to assess the “true” parity in the underlying risk factor exposures for a given portfolio; it also allows investors to understand the active risks that a manager might be taking against his default risk parity position. Using a number of commercial risk parity portfolio returns, we find that traditional asset-based risk strategies, which are diversified in the asset space, can often be dominated by only one or two risk factors (equity and bond factors). In addition, these risk parity portfolios often exhibit very aggressive tactical allocations to the underlying factors, suggesting that active views on asset and/or factor are being expressed in many risk parity portfolios.

Number of Pages in PDF File: 11

Keywords: risk parity, asset allocation, risk factor parity

JEL Classification: G11

Accepted Paper Series