Is Risk Parity A Savior Strategy?

There was an article from the WSJ the other night about a strategy called risk parity and how it is being applied by Ray Dalio and his firm Bridgewater. The basic idea is to allocate assets in the portfolio based on their risk characteristics although I wonder of what they really meant was volatility. The article discussed that this idea is being pitched to various types of pension funds and some are adopting it.

The way the numbers work out in practice getting to the desired balance of risk requires leveraging up the fixed income exposure but not to the extent that the investment banks were levered (a paraphrase of a quote in the article). There are also quotes in the article like this one; "ironically, by increasing your risk in the bonds you are going to lower your risk in your overall portfolio.''

There were quite a few comments noting what a bad idea this is and how it will blow everyone up. Actually there will be a different arc to this, in my opinion. An immediate blowup is not how these things play out. The strategy is likely to work very well for at least several years maybe even outperforming more traditional allocations. This will then draw more an more pools of capital into the strategy which will mute the level of outperformance bringing it in line with more traditional allocations.

Then it will blow up maybe because interest rates will finally start to normalize or maybe for some other reason but this might not be until 2016 and pension fund managers will be left holding the bag not fully understanding the risk they actually took or why it blew up.

Oh and Dalio will have been long gone before this happens regardless of when or why.