Risk parity portfolios with risk factors

Abstract

Portfolio construction and risk budgeting are the focus of many studies by academics and practitioners. In particular, diversification has spawn much interest and has been defined very differently. In this paper, we analyze a method to achieve portfolio diversification based on the decomposition of the portfolio's risk into risk factor contributions. First, we expose the relationship between risk factor and asset contributions. Secondly, we formulate the diversification problem in terms of risk factors as an optimization program. Finally, we illustrate our methodology with some real life examples and backtests, which are: budgeting the risk of Fama-French equity factors, maximizing the diversification of an hedge fund portfolio and building a strategic asset allocation based on economic factors.

The Effect of Possible EU Diversification Requirements on the Risk of Banks' Sovereign Bond Portfolios

“…F C j represents the risk contribution of each ICA factor j to the overall portfolio risk (i.e., how much of the portfolio variance is due to the risk factor j), obtained by its Euler decomposition (Roncalli and Weisang, 2015)…”

Maximizing excess return per unit variance: A novel investment management objective

“…The intuition behind this is that in the limit the minimum variance portfolio approximates a portfolio that equalizes the idiosyncratic risk contribution of each security. This is reminiscent of the equal-risk contribution portfolio literature in, for example, Lee (2011), Roncalli (2014) and Roncalli and Weisang (2015), among others.…”

“…5 To see how (14) comes about we can evaluate the ratio of excess return to volatility for the optimal portfolio which leads to…”

Risk Parity in the Brazilian Market

“…Although the theoretical background for this investment portfolio management approach was developed in the 50's and 60's, it was only after the late 2000 financial crisis that risk parity gained wide interest, given its good performance compared with more traditional strategies (Allen, 2010). Since then, several studies have focused on this approach (Maillard et al, 2008;Schachter and Thiagarajan, 2011;Clarke et al, 2013;Qian, 2011;Roncalli and Weisang, 2016;Bai et al, 2016, among others). An important advantage of using a risk parity approach is that return expectations are not necessary, since setting those expectations is often a point of criticism.…”