Risk Parity and Beyond - From Asset Allocation to Risk Allocation Decisions
41 Pages Posted: 18 Nov 2013
Date Written: November 16, 2013
While it is often argued that allocation decisions can be best expressed in terms of exposure to rewarded risk factors, as opposed to somewhat arbitrary asset class decompositions, the practical implications of this paradigm shift for the optimal design of the policy portfolio still remain largely unexplored. This paper aims at analyzing whether the use of uncorrelated underlying risk factors, as opposed to correlated asset returns, can lead to a more efficient framework for measuring and managing portfolio diversification.
Following Meucci (2009), we use the entropy of the factor exposure distribution as the number of uncorrelated bets (also known as the effective number of bets, or ENB in short), implicitly embedded within a given asset allocation decision. We present a set of formal results regarding the existence and unicity of portfolios designed to achieve the maximum effective number of bets. We also provide empirical evidence that incorporating constraints, or target levels, on a portfolio effective number of bets generates an improvement in out-of-sample risk-adjusted performance with respect to standard mean-variance analysis.
Keywords: portfolio choice, risk parity, diversification, concentration, principal component analysis
JEL Classification: G11, C44, C61
Suggested Citation: Suggested Citation