Risk parity has generated a number of key misconceptions about the technique that uses leverage to balance risk across asset classes to reduce risk, while producing superior risk-adjusted returns.
One deals with the approach itself. Another confuses tactical asset allocation, an alpha strategy, with risk parity, a beta strategy. In addition, critics often ignore a primary benefit of risk parity: achieving both asset growth and liability hedging.
The generic risk parity methodology balances risk among asset classes and maximizes the excess return/risk (or Sharpe) ratio to generate a more efficient long-term strategic portfolio. Most capitalization-weighted policy portfolios concentrate more than 90% of their risk budget in equities. A risk parity portfolio balances risk rather than capital by allowing leverage in the optimization process.
The natural outcome of this type of optimization leverages the low-risk, high-Sharpe-ratio assets, and lowers the allocation to high-risk assets. (This outcome does not necessarily result in equal risk across asset classes as risk parity is often simplistically described.)
“Leverage” has become a loaded term that is often associated with the dangers of leveraging securities, such as stocks. But risk parity leverages Treasury or other risk-free sovereign bonds, not investment-grade credit, using exchange-traded futures contracts. This approach reduces, or even eliminates the counterparty risks and liquidity issues most investment managers associate with leverage. Treasury or other risk-free sovereign bonds also have the desirable characteristic of hedging stocks against downturns because of their flight-to-quality characteristics. We saw this reaction in 2008 when the 10-year Treasury note returned 20.23% while the Standard & Poor's 500 had a total return of -37%. For those who think this is not repeatable because of rock-bottom interest rates, the 10-year Treasury note is yielding about the same now as it did in January 2008.
A critique against using risk parity at this time is a belief that government bonds are now dangerously overvalued, while global equities offer reasonable value. Even if true, this criticism confuses two very different investment strategies. Risk parity replaces the static strategic target typically given to TAA managers as their passive beta exposure. TAA, on the other hand, is an alpha strategy that adds value to the strategic target by shifting assets away from the strategic mix. A more efficient risk parity investment could replace the typical 60/40 stock/bond mix as the underlying beta exposure in a long global portfolio while still incorporating tactical shifts generated by a TAA process. In this way, clients receive the efficient beta of risk parity with, hopefully, true alpha from TAA.