Risk-parity strategies are designed to fare well in different types of markets using a multiasset approach. In the years leading up to the 2008 financial crisis, many practitioners embraced the key tenets of risk parity and used them to develop new strategies. Ideas such as using leverage to harness the higher risk-adjusted returns of fixed-income markets, investing according to risk instead of capital and the diversification benefits of multiple risk premiums beyond equity have become common for sophisticated investors.
However, one area of risk allocation that has not been explored as commonly is the idea of adaptive rather than static risk allocation.
At a high level, risk parity seeks to balance the underlying risks of stocks and bonds and achieve a higher Sharpe ratio (i.e., it is a more efficient portfolio, delivering greater return per unit of risk).
To reframe the problem, if an investor's goal is to maximize Sharpe ratio, is a static risk allocation approach always the answer? Not necessarily. Looking at rolling three-year returns, one gets a different answer on how much equity risk is optimal given market performance.
Exhibit 1 shows the optimal equity risk weight in a portfolio on a monthly basis for the period January 1973 through September 2020. In this exhibit, we define optimal as delivering the highest possible Sharpe ratio.