In terms of implementation, given that asset classes have different levels of risk1 (e.g., equities have higher risk than high quality bonds), an investor would need to use leverage to construct a risk parity portfolio with an expected level of risk (or return) that mirrors that of a traditional allocation. Leverage can be a flexible tool for investors to magnify the expected returns of a strategy, but it does come with risks; in particular, it amplifies losses and may introduce undesired liquidity and counterparty risk to a portfolio. Most risk parity portfolios use some degree of leverage.
Risk parity allocations result in higher allocations to bonds and lower allocations to equities relative to traditional capital allocations, which means they should outperform during times of equity turbulence but may underperform during periods of rising rates. Additionally, since these allocations are not widely implemented in the industry, institutional investors that adopt this allocation methodology need to be comfortable being “different” from peers, that is, having high tracking error to broad peer allocations.
This paper covers risk parity in the context of an asset allocation strategy for institutional investors. Risk parity can be understood more broadly as a methodology for allocating capital/risk to a group of assets. These additional applications are outside the scope of this paper.