Low risk investing and risk parity

This thesis finds evidence of the outperformance of the risk parity (RP) strategies in comparison to the traditional equal-weighted portfolios. The empirical study focuses on backtesting the portfolio strategies by using two datasets, a long sample and a broad sample. The long sample data consists of U.S. common stocks listed in NYSE, AMEX and NASDAQ as well as U.S. government bonds over January 1929 to December 2015. The broad sample consists of global multi-asset index data including stocks, bonds, credit, commodities, real estate and hedge funds over January 2002 to December 2015. Risk parity refers to the asset allocation strategy that diversifies by risk, not by dollars. As stocks are much more volatile than bonds, traditionally diversified portfolios such as equal-weighted portfolio or market capitalization-weighted portfolio are most likely dominated by risks raising from equity markets. An optimal RP portfolio consists of equal risk contribution between and within asset classes. Put simply, a RP investor overweights low risk assets and underweights high risk assets. The main objective of the thesis is to evaluate the performance of two RP strategies, the inverse volatility method and the equal risk contribution method, in comparison to the equal-weighted portfolios. As a RP portfolio typically has a heavy allocation in low risk assets, the strategy requires leverage to raise the expected return to desired levels. Hence, this thesis focuses on analysis of both strategies, leveraged and unleveraged RP portfolios. The main analysis is carried out in several phases including market friction adjusted and unadjusted analyses. In addition, the strategies are tested in different interest rate environments. The performance of the portfolios is measured by realized Sharpe ratios. The study also observes abnormal returns by using a simple regression model. The key findings of the study are as follows: The RP strategies outperform the traditional equal-weighted portfolios on risk-adjusted basis after adjustments for market frictions. The unleveraged RP portfolios deliver higher Sharpe ratios than leveraged portfolios. However, the leveraged RP portfolio still achieves a higher Sharpe ration in comparison to the equal-weighted portfolio. The RP strategies underperform when interest rates are rising moderately or sharply. The equal risk contribution method outperforms the inverse volatility method