October 17, 2012 (PLANSPONSOR.com) – Risk parity is an alternative form of portfolio management that allocates capital based on the underlying risk of asset classes, rather than anticipated returns.
In a research paper, J.P. Morgan Asset Management contends that traditional risk parity has significant drawbacks and recommends an asset allocation model based on factor risk parity.
According to "Diversification: Still the Only Free Lunch?", the biggest problem with traditional risk parity is its high exposure to leveraged fixed-income assets at what looks like an increasingly vulnerable point in the interest rate cycle. Another weakness is that it presumes different asset classes are uncorrelated or have low correlations. In reality, seemingly diverse asset classes can have unexpectedly high correlations because they share common underlying risk factor exposures.
The paper says many institutional investors and consultants have done work on using risk factors as a basis for portfolio diversification. The idea is that asset classes can be broken down into building blocks, or factors, which explain the majority of their risk and return characteristics. A factor-based investment approach enables the investor to theoretically remix the factors into portfolios that are better diversified and more efficient than traditional methods.
However, the paper warns that building and implementing factor-based portfolios from scratch can be challenging and largely impractical for institutional investors, often because they require things like frequent rebalancing and the nimble use of long/short positions to fully optimize the portfolio. More information about improving on risk parity can be found at www.jpmorgan.com/institutional.