The risk-parity portfolio technique offers an alternative portfolio construction methodology to heuristic rules such as “60/40” and traditional quantitative portfolio construction techniques such as mean-variance optimization. Proponents of risk-parity portfolios argue that the traditional 60/40 allocation historically has exposed investors disproportionately to equity market risk and that volatility in these historical returns has been driven primarily by variation in equity market prices.
Risk-parity portfolio construction methodology first divides the world of investable assets into a set of desired asset classes and adjusts the portfolio allocation so that the expected risk contribution of each asset class is equal. This optimal portfolio is then levered, typically using futures contracts in some way, to achieve the desired overall level of risk exposure.
In practice, this technique results in portfolios more heavily weighted toward fixed income than traditional portfolio schemes. Many risk-parity portfolio models also include commodities as an asset class, and some will even incorporate more exotic strategies such as a trend-following component.
It is important to note that the resulting portfolio and performance will be very different depending on the scheme used for classification of assets into various risk buckets and the method chosen to calculate risk metrics for each bucket. Ideally, the specified asset classes will have positive expected returns over a long time period and be minimally or negatively correlated with each other. In theory, however, a pure risk-parity portfolio gives no consideration to asset-class returns and is solely devoted to budgeting risk.
Because risk-parity models tend toward an asset-class mix that exhibits low expected volatility, leverage almost always is applied to produce fund products more aligned with typical investor risk-tolerance and return objectives. In practice, this leverage is introduced via some form of exposure to futures contracts. Some firms offer standard and high-volatility versions of their risk-parity portfolios to provide a suite of products to appeal to investors with a wide range of risk tolerances.
Because the tax treatment of risk-parity products will vary depending on the structure used to house the fund and the underlying financial instruments deployed to achieve the desired leverage, investors considering risk-parity investments should be sure to calculate expected risk and return metrics on an after-tax basis for an accurate comparison to traditional portfolios.
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