Diversification Benefits for Risk Parity

Abstract

We investigate the out-of-sample diversification benefits of risk parity portfolios by analyzing the properties an asset class has to fulfill in order to be beneficial in a risk parity strategy and compare them with benefits present in other heuristic weighting techniques, especially risk-based strategies. We find that risk parity portfolios achieve a superior risk-adjusted return over multiple financial cycles than most other popular weighting strategies while yielding a lower risk exposure and volatility. However, risk parity is more sensitive to the properties of its constituents than other weighting strategies and adding a negative risk premium asset can substantially deteriorate its risk-return profile.

Keywords: Asset Allocation Models, Diversification, Out-of-Sample Portfolio Optimization, Performance Evaluation, Risk Parity

JEL Classification: C52, C61, G11