What Is Risk Parity? Dalio's All Weather, Risk Parity ETFs, and the Year It Broke

Risk parity is a portfolio rule that gives every asset the same share of risk. Not the same share of money. Ray Dalio's All Weather fund made it famous. Today you can hold it through a risk parity ETF or mutual fund.

The catch is leverage. Bonds are calm, so they get a big weight, and the manager borrows to lift the return. That works until stocks and bonds fall together. In 2022 they did.

What is risk parity?

A 60/40 portfolio splits the money. Risk parity splits the risk.

Risk here means volatility, the size of an asset's typical swings. Each holding adds some share of the portfolio's total volatility. That share depends on two things. How big the position is, and how much the asset moves.

Risk parity sets the weights so every share is equal. Two assets, half each. Four assets, a quarter each.

Daniel Snover, founder of PMV Capital, gave the cleanest version on Behind the Ticker. The goal is to "combine those assets in a way to where the systematic risk of each one of them offsets".

What does Ray Dalio have to do with risk parity?

Bridgewater Associates launched All Weather in 1996. Dalio wanted a portfolio that didn't need a forecast. It holds assets that do well in four environments: growth rising, growth falling, inflation rising, inflation falling. Each environment gets roughly equal risk.

Edward Qian at PanAgora coined the term "risk parity" in a 2005 paper. Snover calls it "really an offshoot of the all weather strategy". Same idea, two labels.

The mix people usually quote is a simplified retail version Dalio described in 2014. Thirty percent stocks, 40 percent long-term Treasuries, 15 percent intermediate Treasuries, 7.5 percent gold, 7.5 percent commodities. It's unlevered. That makes it a cousin of institutional risk parity, not a copy. Bridgewater's fund uses leverage.

Why is a 60/40 portfolio mostly a stock portfolio?

Take round numbers near the long-run averages. Stocks at 15 percent volatility. Bonds at 5 percent. Assume, for now, they don't move together.

A position's share of variance is its weight squared times its volatility squared. Stocks: 0.36 times 225, or 81. Bonds: 0.16 times 25, or 4. Stocks carry 81 of the 85 units. That's 95 percent.

So 40 percent of the money does about 5 percent of the risk work. Snover sees the same thing in live portfolios: "stocks are accounting for more than 90% of the risk of that 60, 40 portfolio".

How does risk parity set the weights?

The simplest version weights each asset inversely to its volatility. A third of the volatility gets three times the weight.

Each side now carries half the risk. Real funds add more steps.

1. Measure volatility. A trailing window, often 60 days to three years.
2. Weight inversely to it. Half the risk gets twice the weight.
3. Adjust for correlation. Two assets that move together count as one risk.
4. Scale to a volatility target. Usually with leverage.
5. Rebalance. Monthly or quarterly.

Most funds hold more than two assets. Commodities, inflation-linked bonds and gold are the usual adds.

What's the difference between risk parity and risk budgeting?

Risk budgeting is the general rule. You pick each asset's share of risk up front, then solve for the weights. Risk parity is the special case where every budget is equal.

A manager could give stocks 60 percent of the risk and bonds 40. That's a risk budget. It isn't risk parity.

Thierry Roncalli's 2013 book, Introduction to Risk Parity and Budgeting, is the standard text on the math. One point carries over without the equations. Once you have more than two correlated assets, there's usually no tidy formula. A numerical solver finds the weights.

Why does risk parity use leverage?

Look at the volatility in that second table. About 5.3 percent, against 9.2 for the 60/40. A book that's three quarters bonds behaves like a bond fund.

So the manager borrows. Lever it 1.75 times and volatility climbs back near 9 percent.

The extra 75 percent is financed through futures or repo. Most of it lands on bonds, because that's where the weight sits.

AQR's Cliff Asness, Andrea Frazzini and Lasse Pedersen made the case in a 2012 paper, "Leverage Aversion and Risk Parity." Many investors can't or won't borrow. So they reach for return by loading up on stocks. That leaves low-risk assets paying more per unit of risk. Risk parity borrows to collect the gap.

Which risk parity ETFs and funds exist?

AQR launched a risk parity mutual fund in 2010. Wealthfront added a risk parity fund to some client portfolios in 2018.

The RPAR Risk Parity ETF listed in December 2019, the first ETF built on the approach. It holds global stocks, commodities and gold, inflation-linked Treasuries and nominal Treasuries, with gross exposure above 100 percent. A more levered version from the same sponsor listed in 2022.

Two numbers decide what any of these really is. The volatility target, and the leverage cap. Picture a fund targeting 10 percent volatility at up to three times leverage. It's a different holding from an unlevered fund with the same label.

How do practitioners use the equal-risk idea?

Jerry Prior of Mount Lucas Management described how his firm's managed futures index set sector weights in 2005. It "gave 42 and a half percent to bonds, 32 and a half percent to currencies and 25% to commodities". Bonds got the most because they move the least.

Bond volatility later fell hard. A strict rule would have pushed bonds even higher. The committee didn't. Prior's line: "we value being roughly right on these weights instead of precisely wrong".

What happened to risk parity in 2022?

The design rests on one assumption. When stocks fall, bonds rise or hold. That's what lets a book carry 131 percent in bonds.

For years the data agreed. Take monthly returns of the S&P 500 and intermediate Treasuries. Their trailing 24-month correlation sat below zero at almost every year-end from 2005 through 2021. It hit negative 0.73 at the end of 2011. It was negative 0.37 at the end of 2021.

Then inflation came back. The Federal Reserve raised rates seven times in 2022. Its target went from 0 to 0.25 percent to 4.25 to 4.50 percent. Bonds fell because rates rose. Stocks fell for the same reason. By year-end the correlation was positive 0.54. It stayed positive through 2024.

Here's the levered portfolio from above, run through 2022. The S&P 500 stands in for stocks, the Bloomberg US Aggregate for bonds.

The hypothetical equal-risk book lost more than the 60/40 it was built to beat. The bond sleeve did most of the damage, because that's where the leverage sat.

Financing made it worse. Borrowing near zero is cheap. Borrowing at four percent isn't, and that cost rose all year while the assets it funded fell.

When does risk parity fail?

No manager error is needed. The rule did what it was written to do, in a regime it wasn't built for. Four weak spots matter.

• Positive stock-bond correlation. The 2022 case. Inflation shocks hit both sides at once.
• Volatility targeting. Calm markets mean more leverage. Spikes mean forced selling.
• Financing cost. Leverage is cheap at zero rates and expensive at four percent.
• Estimation error. Twenty assets need 190 correlation estimates, and small changes can swing the weights.

Yang Tang, co-founder of Arch Indices, explained why his indexes skip volatility targeting. When volatility rises, "you would have to reduce exposure, which actually leads to adverse outcomes for investors". His indexes use no leverage at all.

Put Tang next to Prior and the 2022 mechanism is clear. Bond volatility was low in 2020 and 2021, so scaled portfolios held big bond positions going in. Rates moved, volatility jumped, and the rule cut exposure after much of the loss.

Marcos Lopez de Prado's 2016 hierarchical risk parity attacks the estimation problem. It clusters similar assets and skips inverting the covariance matrix. The clustering is its own judgment call, though.

How should an adviser evaluate a risk parity fund?

Read three things in the prospectus before the pitch deck.

1. The volatility target. It sets total risk and how often the fund rescales.
2. The leverage cap. It sets how far the fund borrows in calm markets.
3. The bond sleeve's duration. It decides how hard a rate shock hits the biggest position.

Then ask the manager one question. How did the weights move through 2022, month by month? The answer shows whether the process cut exposure before the damage or after it.

Placement matters too. Snover suggests advisers "leave their stock allocation where it is" and use the strategy in place of part of core bonds.

Risk parity sizes positions by volatility and holds them through whatever comes. An adaptive approach asks a different question: should you hold the risk asset at all when trends turn down? THOR reads price and seeks to reduce drawdowns by moving toward cash. Our pieces on tactical asset allocation and volatility targeting cover the neighbors.

Definitions

• Risk parity. A construction rule where every asset contributes an equal share of portfolio risk.
• Risk budgeting. Assigning each asset a chosen share of risk. Risk parity is the equal-share case.
• Risk contribution. The share of portfolio volatility that comes from one holding.
• All Weather. Bridgewater's 1996 fund, the first large application of the equal-risk idea.
• Volatility targeting. Scaling exposure up or down to hold portfolio volatility near a set number.
• Gross exposure. Long plus short positions as a percentage of capital.
• Stock-bond correlation. How closely stock and bond returns move together. Risk parity needs it low or negative.
• Hierarchical risk parity. A 2016 variant that clusters assets instead of inverting a covariance matrix.

Educational content only. This is not investment advice and not a recommendation regarding any security. Index figures are cited as historical illustration. The 60/40, equal-risk and levered portfolios are hypothetical and exclude fees and financing costs. Correlation figures are computed from monthly returns of ETFs tracking the S&P 500 and intermediate US Treasuries. Funds named are described for education, not endorsed. Managers quoted are speaking about their own approaches on Behind the Ticker. Investing involves risk, including possible loss of principal. Past performance is not indicative of future results.

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