Risk Parity and Beyond - From Asset Allocation to Risk Allocation Decisions

41 Pages Posted: 18 Nov 2013  

Romain Deguest

Fundvisory

Lionel Martellini

EDHEC Business School

Attilio Meucci

ARPM - Advanced Risk and Portfolio Management

Date Written: November 16, 2013

Abstract

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

Deguest, Romain and Martellini, Lionel and Meucci, Attilio, Risk Parity and Beyond - From Asset Allocation to Risk Allocation Decisions (November 16, 2013). Available at SSRN: https://ssrn.com/abstract=2355778 or http://dx.doi.org/10.2139/ssrn.2355778

Romain Deguest

Fundvisory ( email )

48 rue du Chateau Landon
Paris, 75010
France

HOME PAGE: http://www.fundvisory.com/

Lionel Martellini (Contact Author)

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Attilio Meucci

ARPM - Advanced Risk and Portfolio Management ( email )

HOME PAGE: http://www.arpm.co/

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