Berlinda Liu, CFA, Director, Global Research & Design
Phillip Brzenk, CFA, Senior Director, Strategy Indices
Tianyin Cheng, Senior Director, Strategy Indices
The S&P Risk Parity Index Series provides a transparent, rules-based benchmark for equal-risk-weighted parity strategies. These indices construct risk parity portfolios by using futures to represent multiple asset classes and the risk/return characteristics of funds offered in the risk parity space. Because risk parity funds can have different volatility targets, our series consists of four indices with different target volatility (TV) levels: 8%, 10%, 12%, and 15%.
Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, sets the framework for market participants to potentially maximize portfolio returns for a given level of risk. The theory favors portfolio diversification by holding non-correlated assets. That is, it does not view individual asset returns and volatilities in isolation; rather, it takes into account the co-movements, or correlations, of asset returns that comprise a portfolio.
The theory, along with the expectation that long-term asset class Sharpe ratios are similar (Dalio et al., 2015), act as foundational pieces of risk parity. Risk parity strategies propose that portfolio diversification, defined as achieving the highest return per unit of risk, can be maximized when a portfolio’s assets contribute equally to total portfolio risk.
Since the launch of the first risk parity fund, Bridgewater’s All Weather Fund in 1996, many asset managers have offered their version of risk parity to clients. The risk parity industry especially gained traction in the aftermath of the 2008 global financial crisis, growing to an estimated USD 150-175 billion at year-end 2017 according to the IMF (Antoshin et al., 2018).
In the past, such strategies lacked an appropriate benchmark, leaving most investors to benchmark against a traditional 60/40 equity/bond portfolio. The problem with this approach is that a 60/40 portfolio reflects neither the construction nor the risk/return characteristics of risk parity strategies. While portfolio risk is generally considered to be diversified in U.S. dollar terms, the reality is that nearly all of the risk arises from the 60% allocation to equities. Additionally, when a portfolio is equal-risk weighted as opposed to equal weighted, it may lead to superior risk-adjusted returns.
In the first part of this paper, we cover the economic rationale for implementing a risk parity approach in a multi-asset portfolio construction. In the second part of the paper, we give an overview of the S&P Risk Parity Indices.