Risk Parity: Classical Finance Properly Implemented, or Misunderstood?

Abstract

This material comments on “Speculative Leverage: A False Cure for Pension Woes” (May/June 2010).

Notes

¹Although there is no one “original” article proposing risk parity as a strategy, Asness (1996) was an early proponent of levering an asset-class-diversified portfolio. In a Letter to the Editor in this issue, Asness further notes that risk parity, to the extent it owns more bonds and fewer equities than the market portfolio, must be justified as an active tilt, and he offers a justification for such a tilt. The tilt arises by observing that many or most investors are averse to leverage. Thus, investors who desire more risk than the market portfolio will not lever it, as theory suggests, but will instead sell low-risk assets (such as bonds) to buy high-risk assets (such as equities), thereby raising their expected return without leverage. If this bias against leverage exists, then bonds can be underpriced and equities overpriced versus conventional theory, and an investor who is not averse to leverage could choose risk parity as a sort of “leverage arbitrage.” Inker (2010) articulated the case against risk parity (not its naive misapplication as a portfolio of levered bonds). Many other prominent authors have weighed in on the topic.

²Why not government bonds? These bonds (not just “cash”) are part of the riskless asset portfolio, which investors use to defease their liabilities while taking as little risk as possible. See Waring and Whitney (2009).