An EDHEC-Risk Institute study from the Lyxor research chair on “Risk Allocation Solutions” develops a conditional approach to risk parity, which contrasts with standard unconditional risk parity portfolios.
According to the paper, “Towards Conditional Risk Parity – Improving Risk Budgeting Techniques in Changing Economic Environments”, it has become increasingly apparent that a portfolio that seems to be well-balanced in terms of dollar contributions can be extremely concentrated in terms of risk contributions because of differences in volatility and pairwise correlation levels amongst the constituents.
Risk parity has become an increasingly popular risk management methodology within and across asset classes. While intuitively appealing, this approach suffers from one major shortcoming, namely the fact that it is not explicitly sensitive to changes in market conditions. In particular, using the risk parity approach in an asset allocation context inevitably leads to a substantial overweighting of bonds versus equities, which might be a concern in a low bond yield and high dividend yield economic environment.
In this paper the authors introduce three distinct conditional risk parity strategies, explicitly designed to optimally respond to changes in state variables.