Let’s take a look at a way to practically implement risk-parity in a portfolio. A traditional 60/40 mix of stocks and bonds can be leveraged one of three ways. First, through a traditional margin account with the investor being charged the broker call rate + or – an amount relative to their account size. Currently the rate at Fidelity is 6% for balances > $500k, but can approach 10% for smaller balances. . .
A second option would be to use the leveraged mutual funds. Say an investor has the following allocation:
60% SPY (S&P 500 ETF)
40% AGG (Lehman Aggregate Bond ETF)
The investor could then leverage the portfolio to whatever target he desires. For example
for a total of 130% invested. Likewise he could use the Rydex or ProFunds leveraged funds to achieve the risk parity.
30% ULPIX (Essentially 60% Large Cap exposure)
Do to the nuances of how Rydex and ProFunds leverage their portfolios (they attempt to achieve 2:1 on a daily basis) there will be a difference in overall performance.
Third, an investor could also use futures (the prefered method with the institutional crowd) or swaps.
The capital that is freed up by the leverage process can be used for a number of purposes. In this example, a simple additional allocation to bonds is executed. Likewise, the investor may choose to place the capital in other non-correlated asset classes. In many instances investors use the capital in a portable alpha conext (a different topic altogether and the subject of my other blog, World Alpha).