Risk parity has recently garnered significant attention, particularly owing to its strong performance in the last decade. The premise of risk parity as an approach to strategic asset allocation is based on maximal diversification of beta (or risk premiums). However, investors are keenly aware of the increasing difficulty of achieving asset class diversification — particularly in times of crisis.
A number of recent studies have examined the benefits of factor diversification over asset class diversification. The difference is subtle because asset classes are themselves factors (i.e., compensated risk premiums). Equities can be thought of as a growth factor, Treasuries as a deflation factor and commodities as an inflation factor. However, risk premiums extend beyond these traditional factors and can also include, for example, the equity value premium, commodities roll yield and the merger arbitrage premium.
This paper seeks to shed light on risk parity, outline its main advantages and address investors' current concerns with the framework. In our view, by using factor premiums as the building blocks of risk parity, one can address the core concerns around traditional risk parity and offer a very attractive approach to strategic asset allocation.