Risk Parity Equity Strategy with Flexible Risk Targets

Published in The Journal of Investing, Fall 2013.

Executive summary

Unlevered risk-parity equity portfolios have higher Sharpe ratios than cap-weighted indexes but lower absolute volatility. This paper asks how to raise risk to a target level, analogous to 130/30 or "130/0" for long-only leverage, while preserving risk-parity characteristics through equity index futures plus a physical stock book.

For S&P 500 risk parity, a synthetic portfolio of stocks and futures can closely replicate levered targets such as 110% and 130% of index volatility with minimal tracking error and preserved Sharpe ratios. The same futures-based approach fails for minimum-variance portfolios: as futures are added, weights collapse toward cap-index concentration, degrading the structure the investor intended to own.

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