How does risk parity work and why does it use leverage?

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AcadiFi · Accepted Answer

Risk parity allocates capital so that each asset class contributes equally to total portfolio risk (volatility). Traditional 60/40 dollar-weighted portfolios are actually ~90% equity-risk and 10% bond-risk because equities are 3x more volatile than bonds.

**Construction steps**:
1. Identify asset classes (equities, nominal bonds, inflation-linked bonds, commodities, credit).
2. Estimate volatilities and correlations.
3. Size positions so each asset contributes same risk: weight_i proportional to 1/vol_i (for uncorrelated assets).
4. Lever the combined portfolio to target volatility (typically 10-12% annualized).

Example: Equities vol 16%, bonds vol 5%, commodities vol 18%. Pre-leverage weights: 1/16 : 1/5 : 1/18 = 10% : 31% : 9% = total 50% of a dollar. Scale to 100% and lever to hit target vol.

**Why leverage on bonds?** Low-volatility assets have historically shown similar Sharpe ratios to equities (~0.3-0.5). Levering bonds to equity-like volatility gives similar expected return with a smoother path. The portfolio aggregates risk premiums across asset classes more efficiently.

**All-Weather (Bridgewater)** specifically structures around economic regimes:
- Rising growth: equities, commodities, credit.
- Falling growth: nominal bonds, inflation-linked.
- Rising inflation: commodities, inflation-linked.
- Falling inflation: nominal bonds, equities.
Balancing holdings across these regimes leaves the portfolio relatively indifferent to macro scenarios.

**Historical performance (approx)**:
- 10-year annualized return similar to 60/40 (~7-8%).
- Max drawdown typically smaller (~-15% vs -25% for 60/40).
- Consistent across multiple decades - but 2022 was a shock: both stocks and bonds fell, causing -20%+ drawdowns for many risk-parity funds (leverage amplified the losses).

**Risks**:
- **Correlation shift**: if stocks and bonds correlate positively (2022), diversification benefit vanishes.
- **Leverage costs**: rising short rates increase funding cost. 2022 repo rate spike hurt risk parity.
- **Asset vol shifts**: rebalancing to new vols creates turnover and slippage.

**Typical allocations**: AQR Risk Parity, PanAgora, Bridgewater All-Weather. Institutional and family office use ranges 5-20% of portfolio.

How does risk parity work and why does it use leverage?

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