Risk Parity: How Equal-Risk Portfolios Work and Where They Break

Risk parity builds a portfolio where every holding contributes the same amount of risk. Stocks are volatile, so they get a small weight. Bonds are calm, so they get a large one, usually with borrowed money on top.

Balance risk, not dollars. That is the whole idea.

What is risk parity?

A 60/40 portfolio splits the money. Sixty cents to stocks, forty to bonds. Split the risk instead and the picture looks nothing alike.

Equities run about three times the volatility of investment-grade bonds. So a 60/40 portfolio takes roughly 90 percent of its daily movement from the stock sleeve. The bonds barely register.

Risk parity weights each asset inversely to its volatility. Edward Qian at PanAgora named the approach in 2005. Ray Dalio had been running the same logic at Bridgewater since 1996, inside the All Weather fund.

How does risk parity actually work?

1. Measure the volatility of each asset. Managers use a trailing window, usually 60 days to three years.
2. Weight inversely to that volatility. An asset with half the risk gets twice the weight.
3. Adjust for correlation. Two assets that move together are not two sources of risk. They are one.
4. Lever the portfolio to a volatility target. Equal-risk portfolios are low-risk by construction. Low risk means low return.
5. Rebalance on a schedule. Monthly or quarterly, whether the last quarter worked or not.

Step four is where advisors get uncomfortable. And they should.

Without leverage the equal-risk portfolio behaves like a bond fund with a little equity attached. The manager borrows to push the expected return back up. That borrowing is the strategy, not a detail buried in the prospectus.

What does a risk parity portfolio look like in numbers?

Take two assets. US equities at 15 percent annualized volatility, intermediate Treasuries at 5 percent.

Equal risk means weights of one to three. Equities 25 percent, bonds 75 percent. That portfolio moves too little to fund a retirement, so the manager borrows.

Lever it 1.5 times. Now you hold 37.5 percent equities and 112.5 percent bonds. Gross exposure is 150 percent of capital. The extra 50 percent is financed in the repo or futures market.

Run 2022 through it. The S&P 500 returned negative 18.1 percent that year. The Bloomberg US Aggregate returned negative 13.0 percent.

• Equity sleeve: 0.375 times negative 18.1 equals negative 6.8 percent
• Bond sleeve: 1.125 times negative 13.0 equals negative 14.6 percent
• Combined, before financing costs: negative 21.4 percent

A plain 60/40 lost roughly 16 percent in 2022. The equal-risk version lost more. The leverage is the reason, and the bond sleeve is where it sat.

What happened to risk parity in 2022?

The strategy rests on one assumption. Stocks and bonds move in opposite directions when things go wrong.

That held for most of the stretch from 1998 to 2020. Then inflation came back. The Fed raised rates seven times in 2022, from near zero to a 4.25 to 4.50 percent target.

Bonds fell because rates rose. Stocks fell because rates rose. The hedge and the risk asset went down together.

Financing turned at the same moment. Borrowing at 0.25 percent is cheap. Borrowing at 4.25 percent is not. The cost of the leverage climbed while the asset it funded was falling.

That is not a manager error. It is the design working exactly as written, in a regime it was not built for.

What is hierarchical risk parity?

Classic risk parity needs a covariance matrix. With 20 assets that matrix carries 190 correlation estimates. Every one of them carries error.

Marcos Lopez de Prado published an answer in 2016. Hierarchical risk parity clusters assets by how similarly they behave, then allocates down the resulting tree.

It never inverts the matrix. That removes the instability that makes classic risk parity weights jump on small changes in the data.

The tradeoff is that the clustering itself is a choice. Change the distance measure and you change the portfolio.

Which funds run risk parity?

AQR launched its risk parity mutual fund in 2010. The RPAR Risk Parity ETF listed in December 2019 and moved the approach into an exchange-traded wrapper.

Read the prospectus before the marketing. Two numbers decide what you actually own.

The first is the volatility target. The second is the leverage cap. A fund targeting 10 percent volatility at 3 times leverage is a different animal entirely. Same label, very different risk.

When should an advisor not use risk parity?

Three cases, and none of them are subtle.

• Rising-rate regimes. The levered bond sleeve is the largest position in the book. Rate shocks hit it hardest.
• Correlation breaks. When stocks and bonds fall together, the diversification is not there.
• Clients who read statements. Explaining 150 percent gross exposure after a bad quarter is a hard conversation.

Risk parity is a fixed rule about risk. It sizes positions by volatility and holds them through whatever arrives.

An adaptive approach asks a different question. Rather than levering the hedge, it can cut exposure when price trends turn down. THOR reads price and seeks to reduce drawdowns by moving toward cash. Our piece on tactical asset allocation covers how that decision gets made. Managed futures ETFs show a third route to the same goal.

Definitions

• Risk parity. A construction rule where every asset contributes equal risk to the portfolio total.
• Risk contribution. The share of portfolio volatility that comes from one holding.
• Volatility targeting. Scaling total exposure up or down to hold portfolio volatility near a fixed number.
• Hierarchical risk parity. A 2016 variant that clusters assets by similarity instead of inverting a covariance matrix.
• All Weather. Bridgewater's 1996 fund, the first large application of the equal-risk idea.
• Gross exposure. Long plus short positions as a percentage of capital. Risk parity funds usually run well above 100 percent.

Past performance is not indicative of future results. Index figures cited above are public market data. They do not represent the performance of any THOR fund or strategy, and this material is not investment advice.