Recently there has been much debate about risk parity strategies and their use of leverage. However, risk parity is really just a special case of modern portfolio theory. If we take a step back and look at the assumptions, we can better understand the case for and against risk parity and leverage. More importantly, using theory will also allow us to understand when it is appropriate to lever, and when it's time to reduce risk.
The use of leveraged bonds elicits the criticism frequently leveled against risk parity strategies. The aim is to improve the Sharpe ratio of most balanced portfolios by diminishing the preponderance of equity risk. Risk parity portfolios are often constructed by leveraging up the lower-risk asset classes until they have the volatility of stocks, and then constructing a portfolio that holds equal amounts of each leveraged asset. For example, if the risk of stocks is three times the risk of bonds, a stock/bond risk parity portfolio might contain 50% stocks and 50% bonds levered three-to-one, or 50% stocks and 150% bonds. An unleveraged version of that portfolio would contain 25% stocks and 75% bonds.
Risk parity strategies are attractive because they promise higher returns than traditional portfolios with similar levels of risk. But risk parity strategies are leveraged by necessity. Their use of leverage is what allows them to maintain their expected return objective with a risk budget that is more balanced across asset classes than traditional portfolio allocations.
There is another approach to improving diversification while still maintaining the expected return objective. We can identify the tangent portfolio, the portfolio on the efficient frontier with the maximum Sharpe ratio, a measure of the risk-adjusted return. Then we can lever it up to the appropriate level of volatility for the pension plan sponsor. With most reasonable input assumptions, the tangent portfolio lies to the left of traditional portfolio mixes on the efficient frontier. As a result, a levered version of it will provide a higher expected return for the same risk.
Conceptually risk parity uses the same approach, but it also makes simplifying assumptions, including that all of the asset classes have the same Sharpe ratio. Relative to the risk parity portfolio, the tangent portfolio's Sharpe ratio can be higher. And importantly, the tangent portfolio's composition, risk and leverage will be dynamic. They reflect current expectations.