Menu

Updated

How does Risk Parity work?

Unlike traditional portfolio construction methods, which balance a portfolio’s expected return (“mean”) with its risk (“variance”), Risk Parity explicitly aims to equalize the risk contributions of each asset class in the portfolio. The resulting allocations commonly have low volatility as they tend to assign greater weight to asset classes with lower volatility. In order to achieve a higher target volatility and higher expected return, the allocation is leveraged. The quantity of leverage is adjusted periodically to ensure the portfolio targets a fixed level of risk, attempting to stabilize its performance. Historically, portfolios constructed using this approach have outperformed portfolios created using traditional methods with the same level of risk.

To illustrate the mechanics of risk parity, suppose that equities have an annualized volatility of 15% and corporate bonds a volatility of 6%, and the two asset classes have a correlation of 0.15. In a portfolio which is allocated 60% to equities and 40% to corporate bonds, equities actually contribute to 90% of the portfolio’s total risk.

Picture1_-_RP.png

 

To balance your risk across both asset classes, you'd need to invest roughly 29% into stocks and 71% into corporate bonds:

Picture2_-_RP.png

Using this approach, Risk Parity seeks to equalize the risk contribution of each asset class in your portfolio and then applies leverage to scale the risk of the portfolio to a desired expected annual volatility. Wealthfront’s Risk Parity Fund targets an annual volatility of 12%.

Was this article helpful?

The Wealthfront Risk Parity Fund (the “Fund”) is managed by Wealthfront Strategies LLC (formerly known as WFAS LLC), a registered investment adviser and a wholly owned subsidiary of Wealthfront Inc. Wealthfront Strategies LLC receives an annual management fee equal to 0.25% of the Fund’s average daily net assets. Northern Lights Distributors, LLC, a member of FINRA and SIPC, serves as the principal distributor for the Fund. Wealthfront Inc., is not affiliated with Northern Lights Distributors, LLC.

Before investing in the Wealthfront Risk Parity Fund, you should carefully consider the Fund's investment objectives, risks, fees and expenses. This and other information can be found in the Fund’s prospectus. Please read the fund prospectus or summary prospectus carefully before investing. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses.

In order to add the Wealthfront Risk Parity Fund, we must rebalance your portfolio. As part of this process, if we sell positions at a gain, and you do not have sufficient harvested losses to offset those gains, you’ll pay taxes on the net gain.

Investments in the Wealthfront Risk Parity Fund (the “Fund”) involve risk including possible loss of principal. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses. The Adviser's assessment regarding the risk and correlation of the various asset classes and the Fund's exposure to leverage through the use of derivatives may prove to be incorrect and may not produce the desired results. Financial leverage will magnify, sometimes significantly, the Fund’s exposure to any increase or decrease in prices associated with a particular reference asset resulting in increased volatility in the value of the Fund’s portfolio. While such financial leverage has the potential to produce greater gains, it also may result in greater losses, which in some cases may cause the Fund to liquidate other portfolio investments at a loss to comply with limits on leverage and asset segregation requirements imposed by regulations or to meet redemption requests. The net asset value of the Fund while employing leverage will be more volatile and sensitive to market movements. The Fund’s investments in total return swap agreements also involves the risk that the party with whom the Fund has entered into the total return swap agreements will default on its obligation to pay the Fund. The Fund’s use of derivatives may cause the Fund to realize higher amounts of short-term capital gains than if the Fund had not used such instruments. Overall equity market risk, including volatility, may affect the value of individual instruments in which the Fund invests. In addition, the Adviser relies heavily on models and information and data supplied by third parties (“Models and Data”). Models and Data are used to construct sets of transactions and investments and to provide risk management insights. The Fund may be exposed to additional risks when Models and Data prove to be incorrect or incomplete. The Adviser is also newly established and has not previously managed a mutual fund. The Fund is a new fund and as such has limited performance history. The Fund is not suitable for all investors. The Fund should be utilized only by investors who (a) understand the risks associated with the use of derivatives, (b) are willing to assume a high degree of risk, and (c) intend to actively monitor and manage their investments in the Fund. Investors who do not meet these criteria should not buy the Fund. An investment in the fund is not a complete investment program.

3451-NLD-4/23/2018