Risk Parity and the Limits of Leverage

Abstract

The primary investment policy decision is the appropriate level of risk to take and how that risk should be allocated. Any investor with a mix of return-driven (equity-like) and risk-reducing (fixed income) investments will have overall asset returns highly correlated to those of the return-driven component. Equity dominates portfolio risk for a good reason—its role is to deliver returns on risk, and has done so over the long term.The ideal role of investment-grade fixed income in an institutional total fund is risk reduction; leverage distorts that property. Leveraged strategies provide limited risk and return benefits relative to traditional portfolios, except at levels of risk associated with an all-equity portfolio. Investors can navigate difficult times for equities with a market-sensitive investment strategy. Risk parity strategies are most appropriate for consideration as a component of an opportunistic or alternatives allocation, particularly at higher levels of targeted volatility. The benefits of a risk parity strategy as a total fund asset allocation approach are limited relative to the new portfolio risks introduced.

TOPICS: Fixed-income portfolio management, portfolio theory, volatility measures