Risk Parity: An attractive alternative approach or a temporary craze?

Christoffer Fuglsig Pedersen

Student thesis: Master thesis

Abstract

Executive Summary: Does risk parity outperform traditional portfolios? Is the relative performance different under different market conditions? The expected performance of the different portfolios is a key element for the investor’s choice of portfolio. The purpose of this paper is to investigate and analyze the performance of the risk parity portfolio optimization approach, and to examine whether or not it can be expected to outperform other portfolio optimization approaches. Performance and risk was measured using Sharpe Ratio, Modified Sharpe Ratio, Maximum Drawdown and the sensitivity to different market conditions was analyzed by running a regression of the change in interest rates and equity market volatility on portfolio returns. In the empirical study it was found that risk parity has to be leveraged before reaching an acceptable expected return, when analyzing the period from January 2004 to December 2013. The leveraged risk parity and naïve risk parity portfolios where found to significantly outperform a leveraged equally weighted portfolio and an unleveraged mean-variance portfolio for the investment universes with a Danish home bias, but not for the international biased portfolios. These findings correspond well with the findings of Chaves et al (2011) that risk parity can be said to have performed well over the last 30 years but results highly depend on the defined investment universe. Results showed that the two risk parity portfolios showed a negative sensitivity to the change in interest rates larger than the other portfolios. The risk parity portfolios where also found to have a negative sensitivity to equity market volatility, but less than that of the equally weighted portfolio. The findings indicate that there is a risk that risk parity will underperform if interest rates start to climb relative to the mean-variance portfolio.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2014
Number of pages78