On Prudent Risk Parity Implementation

Read an informative paper on Risk-Parity from researchers out of Pimco and Research Affiliates named: The Risk in Risk Parity: A Factor Based Analysis of Asset Based Risk Parity

I may suffer from confirmation bias, but the results are basically confirming my own intuition around the use of return drivers instead of asset classes. See my approach to a Risk-On, Risk-Off Income Portfolio here

To sum-up the paper the authors basically illustrate how traditional Asset Allocation and first generation Risk Parity models are broken, because while they may be diversified across Assets, they are concentrated around the same return drivers.

The authors use a Principal Component Analysis showing that exposure are basically driven by two components, that they proxy as Global Growth and Global Inflation.

Returns on Equities, Real Estate and Commodities are driven by the Global Growth component, whereas the returns on Aggregate Bonds, Treasuries and Investment Grade Credit are mainly loaded by the Global Inflation component.

Running the two orthogonal components against four existing Risk-Parity products a significantly time/regime varying exposure is illustrated.

Using the Black-Littermann model the paper also highlight how an Asset based Risk Parity approach will often imply return assumptions that are both unreasonable, inconsistent and increasing if more Assets driven by the same Return driver are added.

I think this paper does a good job at illustrating how traditional Asset Allocation and even poor Risk Parity portfolios are just not prudent.

Below I will try maintain a list of Risk Parity related Exchange Traded Products and research papers, please contact me with additions:

Research

Bhansali, Davis, Rennison, Hsu & Li: The Risk in Risk Parity

Roncalli & Weisang: Risk Parity Portfolios with Risk Factors

Attilio Meucci: Managing Diversification

Lohre, Opfer, & Orszag: Diversifying Risk Parity

Christoph Kind: Risk-Based Allocation of Principal Portfolios