Risk Parity and its Discontents

Abstract

Risk parity has become a widely-adopted hedge fund strategy with over $300 billion in assets under management globally. We use both realized, net-of-fee returns from risk parity managers and a backtested risk parity portfolio starting in 1951 to evaluate risk parity strategies. We find that risk parity commonly underperforms a traditional 60/40 portfolio delivering lower annualized returns as well as inferior Sharpe and Sortino ratios. We further demonstrate that both the magnitude of bond yield changes and the starting level of bond yields plays a critical role in explaining historical risk parity drawdowns. Finally, we show that a modest modification to the risk parity framework, by incorporating a simple model of expected returns, can materially improve asset allocation outcomes.

Keywords: Risk parity, asset allocation, hedge funds, manager performance, performance attribution, factor analysis