Toward Conditional Risk Parity: Improving Risk Budgeting Techniques in Changing Economic Environments

Abstract

Risk parity portfolios are traditionally constructed by choosing historical volatility as the risk measure. In an asset allocation context, this results in a substantial overweighting of bonds versus more volatile asset classes such as stocks: this is a concern in a low bond yield environment, since the presence of mean reversion in the yield implies that bonds are likely to perform poorly in the next future. In this article, we introduce three distinct risk parity strategies, explicitly designed to respond to changes in interest rate levels. Our results indicate that these strategies deliver higher returns when interest rates start to increase back to their long-term levels, and that the maximum Sharpe ratio portfolio, which also incorporates information on expected returns, is a less robust alternative.

TOPICS: Portfolio construction, fixed income and structured finance, security analysis and valuation, performance measurement