Risk parity - what is going on?

There has been something going wrong with the risk parity approach in 2015 and investors are not happy. The strategy has not fallen apart, but the premise of risk parity will be called into question when the weights lead to under-performance relative to traditional portfolio structures. That said, risk parity has had a good 10 year run especially through the financial crisis.

So what is going wrong? Poor performance in the low volatility asset classes. The charts above show stocks, bonds, credit (LQD), and commodity returns. The foundation of the risk parity approach is to forget ad hoc allocations like 60/40 stock/bonds or cap weighted approaches and focus on volatility. This process means that allocations will be skewed to fixed income and credit over  equity. Under-performance in these sectors will pull down overall returns especially if stocks are moving sideways. This issue gets even worse if there is a commodity allocation which has vastly underperformed this year. Additionally, given the low volatility environment, there can be the use of more leverage to target volatility. This increase in positions to offset low volatility leads to the result of lower returns if there is a down period.

An equal return assumption and with all the allocation based on volatility can be a recipe for low returns if bonds and credit under-perform; however, the alternative of changing weights based return expectations calls for some skill at picking asset classes. This is one of the reasons why, what we call, second generation risk parity may make sense. This enhancement allows for tilts in allocation based on risk premium or trends. If you don't have a view on returns, equate all allocations based on volatility. If you have a view allow for some tilt.