How to Build Risk-Parity Strategies

Many investors want to control for volatility, so instead of ordering their portfolios in old-school stocks-to-bonds ratios, they adopt a risk-parity strategy.

Industry legends like Ray Dalio of Bridgewater Associates have praised such strategies, and hedge funds such as AQR have published data suggesting risk-parity approaches can lead to market outperformance. However, risk parity may be difficult for retail investors to implement.

Let’s delve into all the details of risk-parity strategies and how to build them using Composer.

What is risk parity?

Simply put, risk parity is an investment strategy that seeks to balance the risk contribution of various assets in a portfolio.

Unlike traditional allocation, which focuses on allocating capital across asset classes (such as stocks, bonds, and commodities), risk parity focuses on allocating and distributing risk. With this approach, investments are diversified across asset classes to ensure each asset’s contribution to the portfolio’s overall risk is roughly equal.

Such thinking may sound a lot like Modern Portfolio Theory (MPT), but there are subtle differences. Whereas MPT seeks to maximize returns for a given level of risk or vice versa (i.e., to achieve the efficient frontier), risk parity attempts to reduce exposure to such extremes.

Consequently, risk-parity portfolios tend to be less reliant on equities, and some risk-parity funds run by professional portfolio managers have underperformed compared to more traditional funds. However, risk-parity strategies may still appeal to investors hoping for a stable, diversified approach to wealth management.

Now that we’ve laid out the basics of risk parity, let’s look at simple ways to incorporate it into your portfolio.

Five simple risk-parity techniques

Everyday investors can implement risk-parity approaches in their portfolios using relatively simple strategies, including the following:

1. Diversifying asset classes

You can allocate capital across various asset classes, including stocks, bonds, commodities, and alternative investments. Diversification helps balance risk.

2. Ensuring equal risk contribution

You can assign equal risk weight to each asset class, ensuring no single class dominates portfolio risk. This approach typically involves leveraging less volatile assets to achieve risk parity.

3. Considering risk-parity funds

Some mutual funds and ETFs employ risk-parity strategies, offering an accessible way to gain exposure to these practices.

4. Implementing risk-management measures

You can implement stop-loss orders or options strategies to limit potential losses.

5. Monitoring and rebalancing

You can continuously assess your portfolio to maintain target risk weights. You can also rebalance by adding or trimming positions as asset prices fluctuate.

By adopting these tactics, you can achieve a more balanced risk-return profile in your portfolio akin to professional risk-parity strategies.

Building risk parity investment strategies in Composer

Composer lets you take a playful approach to building portfolios. It’s simple to add assets, structure a portfolio, create trading rules, backtest a strategy, and iterate on it.

For example, you could modify an existing symphony. Let’s use Hedgefundie’s Excellent Adventure Refined ( #HFEAR), which systematically reduces risk ( volatility) by shifting to relatively lower-risk assets, like treasuries, gold, TIPs, and corporate bonds when SPY experiences a 10-day drawdown of 5% or more.

Now, what if we took this logic—systematically reducing risk in response to market changes—and evaluated other ways to implement it? Consider these two approaches:

1. Reducing leverage

Let’s start with reducing the leverage of the portfolio.

Consider two potential scenarios: a “Risk On” scenario and a “Risk Off” scenario. (Risk Off is when the 10-day Max Drawdown of SPY is greater than or equal to 5%; otherwise, the symphony is Risk On.)

Hedgefundie’s Excellent Adventure symphony (#HFEA) holds 3x leveraged ETFs in a static allocation, whereas #HFEAR shifts into unlevered ETFs during the Risk Off trade. In this example symphony, we created a strategy that dynamically reduces leverage—but not to zero.

2. Shifting allocation toward less-risky assets and increasing diversification

What if we shifted asset allocations during Risk Off instead of adjusting leverage? Here, we created a symphony that invests 60% in UPRO and 40% in TMF during Risk On and flips the allocation during Risk Off (40% UPRO and 60% TMF). The shift in asset allocation reduces some of the volatility compared to #HFEA, as shown by slightly lower standard deviation and max drawdown. Still, the symphony remains fully invested in UPRO and TMF, creating a much more volatile ride than #HFEAR.

Putting the strategy together

Let’s combine the concepts of both symphonies.

1. In the Risk Off environment, we’ll simultaneously reduce leverage and the allocation to equities. We’ll also add some more diversification.

2. We can add additional market coverage through leveraged ETFs for 7–10-year treasuries, small-cap stocks, and mid-cap stocks.

3. Further, we can add 20% of the portfolio to diversifiers, which include commodities, TIPs, emerging market bonds, and international stocks.

4. Lastly, for each asset class, we use the inverse volatility weighting to adjust the allocation based on the previous 120-day volatility of each ETF. The symphony is rebalanced weekly.

The result is a risk parity investment strategy that dynamically adjusts leverage and asset allocation based on market data.

In Risk Off, the risk parity allocation is split 40% equities and 60% fixed income, and we use 2x leveraged ETFs (SSO, UBT, UST), except for mid-cap and small-cap equities (IWR, IJR), which are unlevered. The assumption is that smaller-cap stocks are already more volatile and generally perform worse in down markets.

In Risk On, we flip the allocation and invest 60% in equities and 40% in fixed income. We use 3x leveraged ETFs (UPRO, TMF, TYD), except for mid-cap and small-cap equities, which are leveraged 2x.

Before we discuss the results, let’s talk about what makes this symphony great:

1. It’s based on risk parity, which has a solid academic and practical foundation.

2. It adjusts to market environments to reduce risk during turbulent times but maintains its risk-parity orientation.

3. It pulls in additional asset classes (e.g., commodities, TIPs) and sub-asset classes (e.g., international stocks) for diversification.

To summarize the moving parts:

The result

This risk parity strategy returns ~19% annually compared to 11.3% for the 60/40 portfolio. Note that these performance figures are gross, excluding fees and transaction costs, which may significantly impact actual relative performance.

The symphony is slightly less volatile than #HFEAR but experienced a more significant max drawdown during the period. Over the three years from February 8, 2019, to February 7, 2022, risk-adjusted returns for this symphony would have been even more substantial (Sharpe ratio of 1.32 vs. 1.07 for the 60/40 portfolio).

The takeaway

It’s simple to play around and experiment in Composer to see what a risk-parity approach might look like for you. You can backtest, iterate, and build up ideas—all at your own pace.

Our intuitive platform simplifies the complex world of algorithmic trading, offering a wealth of strategies, tools, and resources to help you maximize your investment journey.