Alternative Investing
Understanding Risk Parity
October 1, 2010
Topics - Alternative Investing Risk Parity Portfolio Construction
AQR White Paper
Traditional investment portfolios often give the illusion of diversification when in fact they have concentrated exposure to the equity markets.
Why? Because portfolio allocations to equities are typically 60% or higher (think of the traditional 60/40 portfolio: 60% of its assets in equity, 40% in fixed-income). Since equities have about three to four times the risk of bonds, this allocation leads to a portfolio allocating roughly 90% of its risk budget to equities. In other words, when viewed through the lens of risk, traditional asset allocations are highly concentrated in the equity markets — and not actually diversified at all. The concentration of traditional portfolios can lead to less-consistent performance across economic scenarios, and higher tail risk.
Risk Parity portfolios rely on risk-based diversification, seeking to generate returns that are both higher and more consistent. A typical Risk Parity portfolio begins with a much lower exposure to equities relative to traditional portfolios, and invests significantly more in other asset classes. As a result, the risk budget of the portfolio is not concentrated in equities, but spread more evenly across other asset classes. The key to Risk Parity is to diversify across asset classes that behave differently in various economic scenarios. In general, equities do well in high-growth and low-inflation environments; bonds do well in deflationary or recessionary environments; and commodities tend to perform best during inflationary environments. Having balanced exposure to these three main asset classes may produce more consistent long-term results.
The paper describes a Simple Risk Parity Strategy and demonstrates how it consistently outperforms the typical 60/40 portfolio over nearly 40 years of historical data.
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.