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Risk Parity: The Democratization of Risk in Asset Allocation

Francesco A. Fabozzi, Joseph Simonian and Frank J. Fabozzi
The Journal of Portfolio Management Investment Models 2021, 47 (5) 41-50; DOI: https://doi.org/10.3905/jpm.2021.1.228
Francesco A. Fabozzi
is a doctoral student in data science at the Stevens Institute of Technology in Hoboken, NJ
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Joseph Simonian
is the founder and CIO of Autonomous Investment Technologies LLC in Newton, MA
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Frank J. Fabozzi
is professor of finance at EDHEC Business School in Nice, France
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Abstract

The risk parity investment model for asset allocation offers an alternative to the mean–variance framework. The fundamental idea is that the allocation to different asset classes should not be based on an optimization that targets a specific return with a minimal level of risk but, rather, should generate a portfolio in which the contribution to portfolio risk of each asset class is equal, regardless of its expected returns. In this article, the authors explain the fundamentals of the risk parity investment model and the variants in risk parity strategies due to the selection of the asset classes to be included in the portfolio, the choice of the risk metric, the portfolio risk target, how to obtain leverage, associated leverage, whether the selection of the specific investments within an asset class is made using an active or passive approach, and the tactical risk allocation strategy. In addition to describing the practical aspects of implementing risk parity strategies, the authors identify the various shortcomings of the model and some extensions of the basic risk parity model that attempt to address some of the issues identified by the model’s critics.

TOPICS: Portfolio theory, portfolio construction, risk management, performance measurement

Key Findings

  • ▪ Unlike mean–variance optimization, a risk parity strategy allocates across asset classes such that each asset class contributes equally to portfolio risk, regardless of its expected returns.

  • ▪ In practice, there are variants of the risk parity strategy due to choices made by the portfolio manager, such as selection of the asset classes, risk measure, targeted volatility, degree of leverage, asset selection using active or passive approach, and tactical risk allocation strategy.

  • ▪ The performance of the risk parity strategy has varied, with critics of the strategy identifying theoretical and practical implementation issues.

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Investment Models 2021
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Risk Parity: The Democratization of Risk in Asset Allocation
Francesco A. Fabozzi, Joseph Simonian, Frank J. Fabozzi
The Journal of Portfolio Management Mar 2021, 47 (5) 41-50; DOI: 10.3905/jpm.2021.1.228

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Risk Parity: The Democratization of Risk in Asset Allocation
Francesco A. Fabozzi, Joseph Simonian, Frank J. Fabozzi
The Journal of Portfolio Management Mar 2021, 47 (5) 41-50; DOI: 10.3905/jpm.2021.1.228
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  • Article
    • Abstract
    • A BRIEF HISTORY OF RISK PARITY PRODUCTS
    • ESSENTIAL ELEMENTS OF A RISK PARITY STRATEGY
    • CHALLENGES WITH THE RISK PARITY STRATEGY
    • CONCLUSION
    • ENDNOTES
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