Generalized Risk-Based Investing

Abstract

Risk-based portfolio strategies - such as Minimum Variance, Maximum Diversification, Equally-Weighted and Risk Parity, to name the most famous - have become increasingly popular in the investment industry due to their return-agnostic and risk management features. In this paper, we show that these portfolio construction methodologies are special cases of a generic function defined by two specific parameters: a regularization parameter and a risk tolerance coefficient. We investigate the theoretical properties of this class of strategies, giving expressions for optimized solutions under general and specificrisk models. This allows us to discuss important distinctive features of these portfolios, such as market beta, volatility, or exposure to low-vol/low-beta factors, while not being dependent on a specific sample. We illustrate these theoretical results by an empirical investigation of a large sample of international developed market stocks over the 2002-2012 period.

Keywords: Risk-Based Investing, Minimum Variance, Risk Parity, Maximum Diversification, Equal-Weight, Low-Vol Anomaly

JEL Classification: G11, D81, C60