just finished my Friday night backtests - risk parity does seem to perform pretty well a lot of the times. So when does it not?
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Would love if you could expand on this! I can understand using slower vol signals, but how exactly do you substitute out correlations from the optimisation?
You have a rough model of the factors that drive each asset class (eg equities long real growth, nominal bonds are long real rates and short inflation, commodities long real growth and long inflation, mortgages long real rates, short inflation and rates vol etc)
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Each macro factor contributes some risk and some return. The goal is to have equal risk *in each factor* so you are insensitive to macro outcomes. If two assets are exposed to the same factor you have less of each of them. If they are exposed opposite, you have more of them.
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eg equities and corporate credit are both exposed to real growth which justifies smaller positions than if you balanced risk among asset classes. Nominal govt bonds and commodities have opposite exposure to real growth and inflation which justifies larger positions in both.
End of conversation
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