Top 10 Risk Parity Resources: #9... Allen (2018)

"Risk Parity: Silver Bullet or a Bridge Too Far?"

Summary of RP that blends empirical backtests and some discussion of its theoretical basis. Much of the content is available in other papers, but this chapter does collect and synthesize various aspects of RP. Worth a read if you’ve just started looking into RP, but perhaps less valuable if you’re already familiar with the basics.

Read the original:

Important Points for the RP Investor:

Pages 55-61: Looks at construction of RP portfolios in the context of Modern portfolio Theory (MPT), as developed by Markowitz and Tobin. Good discussion of RP portfolios on the efficient frontier and in comparison to traditional mean-variance optimized portfolios.

Pages 62-63: explores question of whether RP portfolios are efficient. References Asness, Frazzini, and Pedersen’s paper on “leverage aversion,” and their idea that RP portfolios are more efficient because of the general unwillingness (or inability) of many investors to use leverage, resulting in higher risk-adjusted returns for those assets that would require leverage to bring returns up to the level of equities.

Pages 63-66: The most interesting part of the paper, as Allen investigates how leverage functions in RP portfolios depending on the rate and the transaction costs. Allen shows that the higher the borrowing costs (whether from higher interest rates or higher fees or both), the more leverage an investor needs to achieve the targeted return.

Pages 66-70: Comparison of RP with a portfolio based on traditional mean-variance optimization principles (29% stocks, 48% fixed income, 23% REITs) over two decades ending in 2016. There is an interesting finding for this study: while RP outperforms overall, that is essentially due to it superior performance in the financial crisis of 2008-2009; for many other years, the RP trailed the more equity-heavy alternative. Allen suggests that this may be why institutional investors (the audience of this paper) have trouble sticking with the RP approach. It can trail 60/40 or other traditional portfolios for long stretches, causing people to abandon the strategy before the adverse times appear. When markets do shift, it is too late for those investors who gave up on RP.

Pages 70-73: Survey of institutional use of RP portfolios. Individual investors can skip this part.