Second-Order Risk of Alternative Risk Parity Strategies

Journal of Risk, 2019, Vol. 21(3), pp. 1-25

30 Pages Posted: 26 Dec 2017 Last revised: 12 Mar 2021

See all articles by Simone Bernardi

Simone Bernardi

University of Zurich - Department of Banking and Finance

Markus Leippold

University of Zurich; Swiss Finance Institute

Harald Lohre

Robeco Quantitative Investments; Lancaster University Management School

Multiple version iconThere are 2 versions of this paper

Date Written: December 19, 2017

Abstract

The concept of second-order risk operationalizes the estimation risk in portfolio construction induced by model uncertainty. We study its contribution to the realized volatility of recently developed alternative risk parity strategies that invest in an uncorrelated decomposition of the asset universe. For each strategy, we derive closed-form solutions for the second-order risk, subsequently illustrated in empirical analysis based on real market data. The results suggest a relation between the contribution of second-order risk and the sensitivity of a portfolio to single eigenvectors of the covariance matrix of assets' returns. Among the strategies considered, we find the principal risk parity strategy, that invests equally in each eigenvector underlying the variance-covariance matrix, to be immune to second-order risk. For the other strategies, second-order risk can be partially mitigated by means of statistical methods. In particular, we provide evidence for the eigenvalue adjustment being the most effective method for correcting the the SOR bias.

Keywords: Estimation Risk, Second-Order Risk, Portfolio Construction, Risk Parity, Diversification

JEL Classification: G11, D81

Suggested Citation

Bernardi, Simone and Leippold, Markus and Lohre, Harald, Second-Order Risk of Alternative Risk Parity Strategies (December 19, 2017). Journal of Risk, 2019, Vol. 21(3), pp. 1-25, Available at SSRN: https://ssrn.com/abstract=3090624 or http://dx.doi.org/10.2139/ssrn.3090624

Simone Bernardi

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland

Markus Leippold (Contact Author)

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Harald Lohre

Robeco Quantitative Investments ( email )

Weena 850
Rotterdam, 3011 AG
Netherlands

Lancaster University Management School

Bailrigg
Lancaster LA1 4YX
United Kingdom

HOME PAGE: http://www.lancaster.ac.uk/lums/people/harald-lohre

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