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Risk Parity's Year to Forget

Does a rough 2013 foretell future turbulence for risk-parity strategies?

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Risk-parity strategies have burst onto the investment scene during the past few years, an institutional approach that's gained traction with the promise of an "all-weather" strategy, a phrase associated with what many consider the first risk-parity fund, Bridgewater All Weather, a hedge fund run by famed manager Ray Dalio. If the returns of risk-parity mutual funds in 2013 were any indication, however, the weather must have been very inclement indeed.

First, a refresher on the theory behind risk-parity funds. Risk-parity managers argue that the traditional 60/40 stock/bond portfolio derives too much of its risk (as much as 90%) from its equity component. Instead, they allocate on an equal-risk-weighted basis to major asset classes that they believe will offer distinctive portfolio characteristics under different economic regimes. The asset classes used and specific implementation of them varies by fund, but typically covers at least global stocks, bonds, and inflation-hedging assets (usually commodities). In most cases, because the risk approach leads to a high nominal allocation to bonds, the managers use leverage to increase the volatility to a desired level and therefore improve the expected return of the portfolio.

Josh Charlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.