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Market Insight - Macro Risk and Strategic Asset Allocation: Deconstructing Risk Parity Portfolios - June 2013

Our previous papers in this series provided a framework for defining macroeconomic risk and its impact on asset pricing.  Those papers showed how portfolios vary in their long-term return’s correlation with macro economic shocks, which implied that so-called “high cash flow beta” assets should receive a premium relative to the market portfolio. In this paper, we show how our framework can be applied to strategic asset allocation. We label assets as either risk premium or risk hedging assets, depending on their exposure to macroeconomic shocks.  We apply our analysis to a risk-parity portfolio, showing how its relatively high exposure to inflation shocks makes it a risk premium portfolio.  Finally, we present a methodology for designing and testing macroeconomic shocks.