Articles on investing and capital management, with a quantitative focus.
Risk Parity Doesn't Require Leverage
There are many variants of risk parity. Some risk parity hedge funds use leverage. Others dynamically adjust weights (and perhaps leverage) in response to market conditions.
For my own PRP portfolio, I keep things simple and focus on the core features of risk parity design. I don't use leverage, since this adds complexity. I also use constant (permanent) weights.
In my opinion, this kind of portfolio is easier to manage over the long term. It's really just traditional asset allocation with regular rebalancing, which is a tried-and-tested method.
The leverage idea
Here's the reasoning behind leverage in a risk parity hedge fund:
Once the assets in a portfolio are weighted to equal risk (parity), the portfolio theoretically has optimal diversification. You can amplify or leverage the entire portfolio to increase the return while preserving risk parity. The portfolio is still optimally diversified, with all assets contributing equally to risk and reward.
Theoretically, leverage is a dial you control. You can dial up the return as you wish, and a popular hedge fund approach is to dial up the return until it matches regular 60/40. Because the portfolio is still optimally diversified, you can (theoretically) achieve the same return as 60/40 with less risk.
Why don't I use leverage?
I think that it's very important to commit myself to a strategy that I can execute over the long term. The more complex a strategy is, the harder it will be to stick with. A simpler strategy that has fewer moving parts requires less maintenance, and is probably more sustainable.
I can write the entire recipe for PRP in a single sentence:
30% stocks, 50% bonds, 20% gold, with annual rebalancing.
This recipe would become significantly more complex if I start using leverage. From what I've seen in the investment world, complexity tends to cause problems over time. Consider the fate of this popular risk parity fund.
AQR used leverage. However, after recent poor performance, they removed the term 'risk parity' from the fund name and prospectus. They also adjusted their volatility bands, changed their rebalancing methodology, and added completely new strategies to the mix.
What a mess! With many complex details, there are many things that can go wrong.
Leverage isn't necessary
Ray Dalio shared a non-leveraged version of his All Weather risk parity fund, described in detail here. The asset allocation is:
- 30% stocks
- 55% bonds
- 7.5% gold
- 7.5% commodities
This is very similar to my PRP allocation (remember that gold is a commodity).
— Jem Berkes