Tail Risk-Managed Portfolios

Abstract

This paper constructs Tail Risk-Managed (TRM) portfolios in real time, where the scaling of exposures to factors is determined by forecasts of probabilities of VaR violations. Using a set of US Fama-French factors and a set of International equity portfolios, we show that TRM portfolios achieve tail-risk reductions and higher Sharpe ratios relative to both buy-and-hold portfolios and volatility-managed portfolios introduced by Moreira and Muir (JF, 2017). Computations of break-even trading costs suggest that the benefits of TRM portfolios survive trading costs. These results indicate the existence of useful portfolio management strategies to lower exposures to tail-risk without sacrificing desired risk-return combinations.

Keywords: VaR, CVaR, Logit forecasts, Portfolio optimization

JEL Classification: G01, G11, C53