Risk parity (or risk premia parity) is an approach to investment portfolio management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital. The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio can achieve a higher Sharpe ratio and can be more resistant to market downturns than the traditional portfolio.
A good explanation is provided, and a number of research papers are listed here, and here is a quote from this website:Risk parity is a conceptual approach to investing which attempts to provide a lower risk and lower fee alternative to the traditional portfolio allocation of 60% stocks and 40% bonds which carries 90% of its risk in the stock portion of the portfolio (...) The risk parity approach attempts to equalize risk by allocating funds to a wider range of categories such as stocks, government bonds, credit-related securities and inflation hedges (including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial leveraging.
Some institutional investors in Canada are doing it, for example OMERS says it now manages it's "beta" portfolio this way instead of the old 60/40 approach. It all sounds good, but can it be done by Canadian DIY investors with an ETF portfolio rebalanced once a year?The Risk Parity framework seeks to keep portfolio volatility levels constant throughout all market conditions. Allocations are determined by the contribution of risk or volatility of an investment class to the overall portfolio, rather than its anticipated return. As a result, the risk contribution of more volatile asset classes such as equities and commodities is reduced, whilst the risk contribution of less volatile asset classes, such as bonds and interest rates is increased.
It seems obvious that replicating something like the AQR Risk parity fund is not straightforward, as it invests primarily in futures.