Risk Budgeting and Diversification Based on Optimized Uncorrelated Factors

Abstract

We measure the contributions to risk of a set of factors, strategies, or investments, based on "Minimum-Torsion Bets", namely a set of uncorrelated factors, optimized to closely track the factors used to allocate the portfolio. We then introduce a novel definition of contributions to risk, which generalizes the "marginal contributions to risk", traditionally used in banks for risk budgeting and in asset management to build risk parity strategies.

The Minimum-Torsion Bets allow us to also introduce a natural diversification score, the Effective Number of Minimum-Torsion Bets, which we use to measure and manage diversification.

We discuss the advantages of the Minimum-Torsion Bets over the traditional approach to diversification based on marginal contributions to risk. We present two case studies, a security-based investment in the stocks of the S&P 500, and a factor-based investment in the five Fama-French factors.

Keywords: Effective Number of Bets, PCA, Diversification Distribution, Marginal Risk Contributions, Procrustes Problem

JEL Classification: C1, G11