Risk parity is a breakthrough in asset allocation, maybe the most important one that I've seen in my career.
There's a huge benefit to risk balancing and relaxing the no-leverage constraint — both of which set risk parity apart. But I think that there are things that can improve classic risk parity. One is dispensing with the idea of parity, meaning that all of the building blocks in the portfolio need to have identical representation in the outcome of the portfolio. A philosophical commitment to parity is not necessary. In fact, from a portfolio efficiency perspective, parity has demonstrated that it is suboptimal under some conditions. We wanted to understand if those conditions could be established ex ante, and what would be a better allocation approach than parity in those conditions.
Based on our research, we have set up a methodology to identify when it makes sense to defect from a risk-balanced portfolio. Based on bond market signals and stock market signals we make an ex-ante determination on the market state.
Bond market investors are good at worrying about what can go wrong — recession, deflation or financial stress. Stock market investors, on the other hand, tend to be more adept at evaluating what can go right. Conditions in equity markets that are discernable and unusual tend to be positive ones.
While the inputs to our algorithm are stock and bond conditions, the output carries with it implications for all asset classes. The way that these conditions interact is also very powerful, offering additional precision to the diagnosis of markets.
Based on the inputs, we have established four defined market states: capital preservation, neutral, bullish and highly bullish. The majority of the time, the market state will be neutral, and a risk-balanced approach makes sense here.