Abstract

Minimum-variance portfolios and equally weighted portfolios have recently prompted great interest from both academic researchers and market practitioners because their construction does not rely on expected average returns and, therefore, is assumed to be robust. In this article, the authors consider a related approach in which the risk contribution from each portfolio component is made equal, maximizing the diversification of risk, at least, on an ex ante basis. Roughly speaking, the resulting portfolio is similar to a minimum-variance portfolio subject to a diversification constraint on the weights of its components. The authors derive the theoretical properties of such a portfolio and show that its volatility is located between those of minimum-variance and equally weighted portfolios. Empirical applications confirm that ranking. Equally weighted risk contribution portfolios appear to be an attractive alternative to minimum-variance and equally weighted portfolios and, therefore, could be considered a good trade-off between the two approaches in terms of absolute risk level, risk budgeting, and diversification.

Scientific Portfolio AI- Generated Summary

This paper discusses the equally-weighted risk contributions (ERC) portfolio, a robust approach to portfolio construction that maximizes diversification of risk. The ERC portfolio is similar to a minimum variance portfolio subject to a diversification constraint on the weights of its components. The authors derive the theoretical properties of such a portfolio and show that its volatility is located between those of minimum variance and equally-weighted portfolios.

The ERC portfolio is constructed by assigning equal risk contributions to each asset in the portfolio. This means that each asset contributes equally to the overall risk of the portfolio, regardless of its size or expected return. The authors show that this approach leads to a more diversified portfolio that is less sensitive to the input parameters than the traditional mean-variance optimization approach.

The authors provide empirical evidence that the ERC portfolio outperforms other portfolio construction approaches in terms of risk budgeting and diversification. They compare the ERC portfolio to the minimum variance and equally-weighted portfolios in three sample applications: an equity US sectors portfolio, a global equity portfolio, and a fixed income portfolio. In all three cases, the ERC portfolio outperforms the other two portfolios in terms of risk budgeting and diversification.

The authors also provide concentration and turnover statistics for each portfolio construction approach. They show that the ERC portfolio has lower concentration and turnover statistics than the minimum variance portfolio, which is known to suffer from asset concentration. The ERC portfolio also has lower turnover statistics than the equally-weighted portfolio, which suffers from a lack of risk monitoring.

Overall, the ERC portfolio is a robust approach to portfolio construction that maximizes diversification of risk. It is less sensitive to the input parameters than the traditional mean-variance optimization approach and outperforms other portfolio construction approaches in terms of risk budgeting and diversification. The ERC portfolio is a useful tool for investors who are looking for a more diversified and robust portfolio construction approach.