How Risk-Parity Funds Can Intensify the Sell-Off

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By Dr. Sonu Varghese

An interesting article in the Wall Street Journal discussed concerns that risk-parity funds could be forced to sell amid surging volatility, exacerbating the sell-off. Risk-parity funds build portfolios based on “risk” (or volatility in its simplest form), as opposed to dollar weights. A traditional 60-40 stocks-bonds portfolio actually has about 90% of its total risk coming from its allocation to stocks. In its simplest form, risk-parity seeks to have a more equitable allocation to risk from its allocations.

Bridgewater, headed by Ray Dalio and one of the largest hedge funds in the world, was one of the first firms to implement a risk-parity portfolio in 1996 called the “All Weather Portfolio”. Quoting from their white paper, The All Weather Story:

“Low risk/low-return assets can be converted into high-risk/high-return assets.” Translation: when viewed in terms of return per unit of risk, all assets are more or less the same. Investing in bonds, when risk-adjusted to stock-like risk, didn’t require an investor to sacrifice return in the service of diversification. This made sense. Investors should basically be compensated in proportion to the risk they take on: the more risk, the higher the reward.

This results in a high volatility asset like stocks making up only a small portion of the portfolio, while low volatility assets like bonds dominate. A key element of this is for these assets to be negatively correlated with each other (as we will see below).

Risk parity portfolios have only gotten more popular over the previous decade as yields collapsed, including at AQR Capital Management LLC, which managed $26.6 billion in risk-parity strategies as of June. Note that commodity trading advisors have used volatility based position sizing since at least the 1980s.