A Step-by-Step Guide to Optimising Risk Parity

With risk parity, it’s not where you go; it’s where you start from.

Risk parity can be a useful tool in a portfolio, but investors should have an eye to optimise, rather than control risk—and a team from asset manager Robeco has come up with a process to do it.

A paper entitled “Risk Parity Versus Mean-Variance: It’s All in the Views” sets out a three-step process investors should take to ensure they are getting the best out of their portfolios.

The authors suggest that at the outset is very difficult to pre-estimate risk premia—so why try?

“Start by calculating the risk parity portfolio, which equalizes each asset’s contribution to portfolio risk,” the authors said. “In step two, apply ‘reverse portfolio optimisation’ and derive the implied risk premia. These risk premia would maximize the portfolio’s Sharpe ratio. In step three, adjust the implied risk premia according to the confidence placed in one’s ex-ante views.”

After completing this set of steps, the investor should end up with a portfolio positioned somewhere between the initial risk parity portfolio, which represents no confidence in one’s ex-ante views, and a maximum Sharpe ratio portfolio, which represents full confidence in them.

“The key problem in portfolio optimisation is not the calculation of the optimisation but the specification of the inputs, notably the views on ex-ante risk premia,” the authors concluded. “In this paper, we proposed a practical portfolio selection framework that allows an investor to position herself in the continuum between these extremes.”

An investor can use these points to construct their own view and thereby optimise their investment strategy.

“This three-stage portfolio selection process is very similar to the Black and Litterman [1991,1992] procedure,” the authors concluded. “The difference is that we do not start from a market-cap weighted portfolio but instead take the risk parity portfolio as the neutral starting point. Note that we take the risk parity portfolio as a benchmark for our ex-ante views on risk premia instead of a generator of superior risk-adjusted returns per se.”

The full paper by Daniel Haesen, Winfried G. Hallerbach, Thijs D. Markwat, and Roderick Molenaar can be downloaded here.

If you use a risk parity strategy or would not even consider doing so, tell us why in Chief Investment Officer’s 2014 Risk Parity Survey.

Related content: Sharpe Parity: the New Risk Parity? & 2013 Risk Parity Investment Survey