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.

In AQR's case, these risks are broken down into four major "buckets": equity, fixed income, inflation, and credit and currency. The fund maintains equal weighting in each, and also uses a global macro overlay to adjust exposures when conditions merit it.

Criticisms
The approach is not without critics. For starters, risk-parity funds typically use both leverage and futures contracts. Leverage can increase the risk of a fund, although risk parity managers say they take this additional volatility risk into account when constructing their portfolios.

And there are other beefs. "The problem with this strategy is that it relies on historical data and assumes that risk is static," says Lee Munson, chief investment officer at Portfolio LLC in Albuquerque, N.M.

"My main issue with risk-parity models are that they don't use market information, especially valuation data," he adds. Munson points to the treasury market, which he says is currently overvalued but has had low--albeit increasing--volatility.

"Our firm uses a more dynamic approach that still considers risk, but also pricing and valuation data of each asset class," Munson says.

Risk parity managers counter that valuations across asset classes are generally correlated. "Stocks and bonds have seen declining risk premiums for 30 years, so both could be overvalued, which suggests again the value of diversification that is inherent in risk parity portfolios," says Hurst from AQR.

And AQR believes that the data supports its approach. "The empirical data suggests that risk and return are strongly related," says Yao Hua Ooi, a principal and portfolio manager at AQR. "Different asset classes pay you about the same per unit of risk."

Limited Track Record
Although Morningstar doesn't have a formal risk-parity fund category, it says there are more than 25 funds which follow a risk-parity strategy and which have nearly $9 billion in assets under management. The oldest funds in the group are the different share class versions of the Invesco Balanced-Risk Allocation fund, which were rolled out in June 2009. Columbia and Putnam also have multiple share class versions of the same risk-parity strategy.

"Invesco has been the biggest retail strategy in terms of gathering assets, while AQR has has the best pedigree because it's been doing risk parity work in the institutional space and are a major player there," says Morningstar analyst Josh Charlson.

"I think it's definitely growing and starting to gain more credibility," he adds, citing  both Invesco's success in gaining assets and recent academic research supporting the theory behind the risk-parity strategy.

The Salient Risk Parity Fund (SRPFX), which began trading in July and is the newest kid on the block, doesn't have much to go on yet. The Columbia Risk Allocation Fund (CRACX), which debuted in June and so far has collected only $160,000 in assets, but has gained more than 10% over the past three months.

Invesco Balanced-Risk Allocation Fund (ABRCX) has $1.6 billion in assets and has returned 9.44% year-to-date. The fund has earned a 5-star rating from Morningstar and returned 11.72% annually during the 3 years ending 9/26/2012, beating the Morningstar Moderate Target Risk category by 2.69% a year.

The AQR Risk Parity Fund (AQRNX), launched in late 2010, bested the same category in 2011--a 5.13% return versus 0.59%, and is up 11.34% YTD, versus the category return of 8.47%. The Putnam Dynamic Risk Allocation Fund (PDRFX) is up 11.40% YTD.

And the Managers AMG FQ Global Essentials Fund (MMAVX), which launched in January 2010 and currently has $128.7 million in assets, has returned 8.23% YTD. Morningstar says its 3-year annualized performance is 9.36%, versus a category average of 7.43.

The expense ratios for these funds range from 1.26% to 2.15%. Although they are more expensive than balanced funds, the mix of stocks, bonds, commodities and currencies makes them closer to alternative products in portfolio composition, and their expenses compare favorably to other alternative-themed funds.

Risk-parity funds can be used as supplements to core portfolios, adding multiple asset class exposure and increasing diversification while maintaining moderate risk targets. For advisors considering expanding asset class exposure, these funds offer an intriuging and comprehensive approach. That is, if they had a clear idea how to position them.

"It [the risk-parity strategy] is evolving, and it's hard to know where to exactly place it in investor portfolios," Charlson says. "So that's one of the challenges in terms of the role it fulfills."