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The idea of risk-parity has been around for a number of years, if not by name, certainly by concept. Risk-parity is an alternative method of constructing portfolios compared to the more common approach of allocation by capital. Instead of building a portfolio around an asset allocation plan using cap size (large, medium, and small) and asset style (value, blend, and growth), the emphasis is placed on allocation of risk. Portfolio creation around the concept of risk is currently very popular as it worked well over the last twelve years. What might a "risk-parity" portfolio look like going forward and how does it compare to a capital allocation portfolio?

Using a set of eleven ETFs and applying an analysis using Geoff Considine's Quantext Portfolio Planner (QPP) software, what do the future projections look like? The following screen shot is an adaptation of the "Swensen Six" portfolio discussed in this article. Setting an expected growth for the S&P 500 at 7.0%, the capital allocation portfolio is expected to grow at 8% annually over the next year with a projected portfolio uncertainty of just under 15%.

A five-year period was selected so as to span the last bear market. While the above figures look to the future, examine the historical results. This portfolio returned several times the performance of the S&P 500 (no dividends) with a lower standard deviation.

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What are the results if we use the same set of ETFs, but give equal weight to risk? The following screen shot is a QPP analysis of the same set of ETFs, only this time the percentage allocated to each ETF is risk adjusted. As one might expect, a high percentage is allocated to TIP as this ETF carries a small variance value.

Equal weight according to risk resulted in a superior five-year performance at a lower risk. The risk adjusted portfolio had an 11.1% standard deviation over the five-year period whereas the capital adjusted portfolio showed a 17.3% standard deviation. When the same set of ETFs were risk adjusted, performance increased and portfolio volatility decreased. Over this five year period, this is a winning combination.

If we examine the projections over the next year we see the projected growth is down to 5.6%. Without juicing the portfolio in any way, the outlook for this risk adjusted portfolio is to underperform the S&P 500. Critics of the Risk-Parity model, as shown in the following analysis, argue that equal weighting according to risk functions well during certain market cycles, but will fail in bull markets. Knowing when to use either a capital allocation or risk adjust allocation model is a never ending problem.

(click to enlarge)

Source: Portfolio Construction: Risk Vs. Capital Allocation