Market Integration: A Risk Budgeting Guide for Pure Alpha Investors
21 Pages Posted: 6 Mar 2007
Date Written: November 25, 2006
A long-short portfolio strategy is constructed based on earnings yields forecasts and a shrunk covariance matrix. Positions are modied with an innovative technique of time-varying risk budgeting based on an integration measure. We consider a sample of 14 developed equity markets indexes for the period 01:1993 to 08:2006.
Our resulting market neutral strategy has an information ratio of 1,2 compared to 0,6 for a strategy without risk budgeting. We rely on a Principal Components Analysis to extract the factors with which we build an integration measure and we relate these factors to the framework of an asset pricing model. We have also used a shrinkage method to correct the covariance matrix ensuring a better risk measurement and robustness in our optimizations. And we forecast expected returns with forward earning yields.
Keywords: Market Integration, Long-Short, Covariance, Shrinkage, risk budgeting, Portfolio Selection, Principal Components
JEL Classification: C61, G11, G15
Suggested Citation: Suggested Citation