Active Risk Budgeting is better than the Tangency Portfolio
15 Pages Posted: 2 May 2019 Last revised: 15 May 2019
Date Written: January 1, 2019
In this paper, we show empirically that Active Risk Budgeting is a superior portfolio construction methodology to the tangency portfolio method postulated by Mean Variance Optimization. We compare the performance of Active Risk Budgeting and Tangency Portfolio in a series of systematic experiments as we gradually increase the predictive accuracy of the input signal. We find that almost always Active Risk Budgeting has better returns. Only when the signal used for portfolio construction perfectly knows the Sharpe Ratio of the securities in the next five days does the performance of the tangency portfolio catch up to Active Risk Budgeting. Given the results, we would recommend the use of Active Risk Budgeting in portfolio construction for active investment strategies on derivatives.
Keywords: Portfolio Construction, Position Sizing, Managed Futures, Portfolio Optimization, Risk Budgeting, Risk Parity
JEL Classification: C00, C10, C45, C50, G00, G11
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