Shrinkage Estimation in Risk Parity Portfolios

26 Pages Posted: 18 Nov 2021 Last revised: 16 Feb 2022

See all articles by Nabil Alkafri

Nabil Alkafri

WHU - Otto Beisheim School of Management

Christoph Frey

Joh. Berenberg, Gossler & Co. KG; Lancaster University - Lancaster University Management School

Date Written: November 8, 2021

Abstract

We investigate the impact of shrinkage estimation techniques for the moments of asset returns on risk-parity portfolios. In contrast to mean-variance portfolios, the risk contributions of individual assets in risk-parity portfolios are fixed a priori. This additional restriction stabilizes empirical portfolio weights in time. We show that the marginal risk budget for each portfolio asset indeed serves as a natural shrinkage target. Hence, we provide a new perspective on risk-parity portfolios. In an extensive empirical application, we compare and combine the various shrinkage strategies to popular risk-based approaches from the literature. We find that while using shrinkage estimators in risk-parity portfolios enhances out-of-sample performance based on several criteria, traditional covariance shrinkage estimators dominate all other strategies in high-dimensional settings.

Keywords: Estimation risk, regularization, asset allocation, portfolio optimization, variance-covariance shrinkage

JEL Classification: C13, C52, C58, C61, G11

Suggested Citation

Alkafri, Nabil and Frey, Christoph, Shrinkage Estimation in Risk Parity Portfolios (November 8, 2021). Available at SSRN: https://ssrn.com/abstract=3958710 or http://dx.doi.org/10.2139/ssrn.3958710

Nabil Alkafri (Contact Author)

WHU - Otto Beisheim School of Management ( email )

Burgplatz 2
Vallendar, 56179
Germany

Christoph Frey

Joh. Berenberg, Gossler & Co. KG ( email )

Neuer Jungfernstieg 20
Hamburg, 20354
Germany

Lancaster University - Lancaster University Management School ( email )

Bailrigg
Lancaster, LA1 4YX
United Kingdom

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