21 August 2024
For many investors, the days of the traditional 60/40 split between stocks and bonds are seen as yesterday’s strategy. While there are many alternatives, risk parity is becoming popular amongst professional investors looking at ways to leverage risk while maintaining a degree of diversification. So, how does risk parity work, and in what scenarios is this popular?
Traditional investment strategies work on allocating funds to different asset classes based on fixed percentages. Risk parity turns this strategy on its head, instead looking to equalise the risk contribution of each asset class in your portfolio. This means no single asset is dominant when looking at the overall risk. If we look at the investment spectrum for this type of strategy, we have bonds with relatively low volatility to the left, and to the right, we have equities with relatively high volatility and other asset classes in between.
Bonds tend to receive a higher allocation of funds to offset the risk of investing in equities. This also offers potential for leverage, which we will cover later in the article.
This type of strategy is more popular for those with a long-term approach to investment, looking for "smoother" returns. It offers an element of true diversification because this is not done by static asset class allocation but by the risk contributions of different asset classes. It's important to remember that, due to diversification, there will be an element of underperformance if equity markets are rising. On the flip side, when equity markets fall, the downside will be limited due to the exposure to low-volatility (in relative terms) bonds.
While we are focused on bonds and equities at either end of the investment spectrum, the risk parity investment strategy is not limited to these asset classes. Many investors will include stocks, bonds, commodities, and even real estate, gold, and cryptocurrencies in the mix. Each of these asset classes has a different risk rating, where the risk is measured by volatility.
As we touched on above, underinvesting in bonds will reduce the degree of protection and leverage exposure to growth assets such as equities. This needs to be managed very carefully because it will also leverage losses on the downside.
The foundations of the risk parity investment strategy are based on the correlation and volatility of assets compared to markets and each other. While brokers may have access to this information, it can be difficult for private clients to obtain up-to-date risk data. Consequently, you may be behind the times and there is also an element of additional trading costs that need to be considered.
It is also important to recognise that due to the heavy focus on bonds—seen as a low-risk/low-volatility asset class—there is enhanced exposure to interest-rate movement. Interest rate movements will cause valuation shifts within the bond market, which, in a way, is at odds with the low volatility tag on this asset class. Something to watch out for!
Using the risk parity investment strategy, it is easy to leverage exposure to growth stocks by reducing your exposure to bonds. Consequently, the risk parity profile must reflect an individual's risk tolerance. The risk tolerance will take into account financial goals, time horizons and liquidity requirements.
As with any semi-automated approach to asset allocation, as a consequence of market movements, failure to monitor and tweak asset allocations could lead to unintended risk concentrations when using risk parity. We touched on this above, but there is also the potential for higher transaction costs and, in some cases, tax implications.
Risk parity offers an interesting approach to portfolio diversification based on asset volatility as a measure rather than static asset allocation. Increasing or decreasing exposure to the bond market will change the perceived leverage of any portfolio using this strategy. To maximise the benefits of this approach, you will need access to up-to-date volatility figures and an almost robotic approach to risk tolerance and changing asset allocations.
While bond involvement in your asset allocation will lead to some underperformance if equity markets are rising, the strategy provides some protection on the downside and potentially "smoother" returns in the longer term. As with any investment structure, it's important to speak with your financial adviser to ensure that you are taking the correct course of action for your situation.
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