leverage aversion and risk parity - nyu stern.pdf

Leverage Aversion and Risk Parity *+ Clifford Asness, Andrea Frazzini, and Lasse H. Pedersen This draft: May 18, 2011 Abstract. We show that leverage aversion changes the predictions of modern portfolio theory: It causes safer assets to offer higher risk-adjusted returns than riskier assets. Consuming the high risk- adjusted returns offered by safer assets requires leverage, creating an opportunity for investors with the ability and willingness to borrow. A Risk Parity (RP) portfolio exploits this in a simple way, namely by equalizing the risk allocation across asset classes, thus overweighting safer assets relative to their weight in the market portfolio. Consistent with our theory of leverage aversion, we find empirically that RP has outperformed the market over the last century by a statistically and economically significant amount, and provide further evidence across and within countries and asset classes. * Clifford Asness is at AQR Capital Management, Two Greenwich Plaza, Greenwich, CT 06830, email: Cliff.Asness@. Andrea Frazzini is at AQR Capital Management, Two Greenwich Plaza, Greenwich, CT 06830, e-mail: Andrea.Frazzini@. Lasse H. Pedersen is at New York University, AQR, NBER, and CEPR, 44 West Fourth Street, NY 10012-1126; e-mail: lpederse@; web: /~lpederse/. We would like to thank Antti Ilmanen, Ronen Israel, Sarah Jiang, John Liew, Mike Mendelson and Larry Siegel for helpful comments and discussions. + The view