Volatility made an unwelcome but expected February return to the capital markets. The CBOE Volatility index's largest close-to-close point increase on Feb. 5 abruptly ended a period of unparalleled tranquility, marked by the index's all-time low just months prior.
Pundits and investors alike scrambled to identify the cause of these market gyrations and soon began crafting narratives that focused on increasing inflation expectations, growing concerns of rising interest rates and selling pressures from so-called "volatility targeting" strategies. This latter category included a menagerie of strategies, such as trend-following commodity trading advisers, VIX-linked exchange-traded products and risk parity strategies.
Risk parity's perceived role in the equity market sell-off and accompanying volatility spike was particularly notable, revealing what can only be described as a broad-based misunderstanding of the structure, implementation and influence of risk parity strategies by the financial press and many industry players.
It's easy to see how the unfamiliar investor could assume that risk parity is a homogenous investment product implemented in a standard, uniform fashion. But risk parity is, in actuality, an asset allocation philosophy embraced by a relatively small number of investment managers (fewer than 10 in our self-defined universe) with unique views and approaches. We need to tear down the all-risk-parity-funds-behave-the-same straw man and exonerate this strategy as a culprit in the recent market pullback.
The risk parity philosophy focuses on balancing the volatility contributions of a diversified pool of risk premiums. For allocation purposes, the risk premiums used within these strategies are typically grouped into three categories: growth related, deflation related and inflation related assets. Additionally, the strategies' overall volatility target tends to be roughly 10%, which mirrors the historical volatility of a traditional 60/40 portfolio. Nearly all risk parity managers will adhere to this framework of balancing risks across these broad asset categories.
But this is where the similarities end. An investment manager can structure a risk parity fund in many different ways, with the breakdown of asset categories among the biggest differentiators. As previously stated, asset classes are selected based on sensitivities to macro factors, such as rising or falling economic growth and inflation; but meaningful differences in exposures between risk parity funds still exist. Figure 1 highlights the range of asset classes that risk parity managers can use — from the most common, such as large-cap equities and investment-grade bonds, to the more unique investments, like inflation-linked derivatives products that can drive meaningful performance dispersion between funds over shorter time periods.