By Nathan Greenwald

Advisors striving for diversified portfolios have a relatively new approach to add to their toolbox in the form of risk-parity funds, which attempt to diversify exposure across asset classes.

The risk parity approach was pioneered by institutional money manager Bridgewater Associates, which introduced the first risk-parity fund in 1996. Other asset management firms followed suit in subsequent years at the institutional level, and the strategy has migrated to the retail mutual fund space during the past three years, with funds now being offered by a half dozen fund families--AQR Funds, Invesco, Putnam, Managers Funds, Columbia, and Salient Funds.

How do risk-parity funds differ from typical diversified portfolios? Balanced funds and other diversified mutual funds traditionally allocate fixed dollar percentages to desired asset classes. Classic balanced funds have enshrined the 60% stocks/40% bonds ratio as their target.

This approach, while intuitively simple, creates portfolios with large exposures to specific kinds of risk. "A 60/40 balanced fund has about 80-90% of its risk allocation to equities," says Brian Hurst, a principal and portfolio manager at AQR. "The returns of the fund will thus be highly dependent on equity market returns. In 2008, for example, these funds experienced losses almost as great as the equity markets."

The 60/40 approach tends to do well during periods of economic growth and moderate inflation, but tends to fall short during bear markets and less benign macroeconomic environments.

That means balanced funds aren't really balanced when you examine the sources of volatility and risk in the portfolio. "The traditional approach is heavily concentrated in equity risk, but in risk parity all assets classes matter," Hurst says. "Risk parity portfolios depend less on any one market and are really just a bet that diversification will continue to work."

Risk-parity funds attempt to achieve diversification by allocating assets based on the risk level of each asset class. The funds target a given level of volatility and then construct a portfolio which, based on historical volatility measurements, will remain diversified and contain a constant level of expected volatility. 

This often means lower equity exposures, and additional weightings in commodities and inflation-protected bonds. "The practical outcome of risk-parity thinking is to add more inflation hedges to the conventional 60/40 portfolio, reducing equities' volatility contribution," Samuel Lee, a Morninstar analyst, wrote in a report.

Ultimately, the goal is to construct a fund that will be truly balanced regarding varying sources of risk in the capital markets, in hopes of providing a desired outcome in differing macro environments.