Abstract

Portfolio construction and risk budgeting are the focus of many studies by academics and practitioners. In particular, diversification has spawn much interest and has been defined very differently. In this paper, we analyze a method to achieve portfolio diversification based on the decomposition of the portfolio’s risk into risk factor contributions. First, we expose the relationship between risk factor and asset contributions. Secondly, we formulate the diversification problem in terms of risk factors as an optimization program. Finally, we illustrate our methodology with some real life examples and backtests, which are: budgeting the risk of Fama-French equity factors, maximizing the diversification of an hedge fund portfolio and building a strategic asset allocation based on economic factors.

Scientific Portfolio AI- Generated Summary

The paper “Risk Parity Portfolios with Risk Factors” focuses on portfolio construction and risk budgeting, providing a method to achieve portfolio diversification based on the decomposition of the portfolio’s risk into risk factor contributions. The authors aim to address the limitations of traditional diversification approaches and provide a systematic methodology for constructing diversified portfolios.

The paper begins by highlighting the importance of portfolio diversification and the various heuristic approaches that have emerged to tackle the construction of diversified portfolios. These approaches include equally-weighted, minimum variance, most diversified portfolio, equally-weighted risk contributions, risk budgeting, and diversified risk parity strategies. While these approaches pursue diversification, they may lead to solutions with hidden risk concentration, prompting the authors to propose a new method based on risk factor contributions.

The authors establish the relationship between risk factor and asset contributions to overall portfolio risk. They demonstrate that the equally-weighted risk factor contributions approach is equivalent to a risk-budgeting solution on the assets of the portfolio with a specific risk budgets profile. The paper also examines different optimization programs to obtain the desired outcome, providing a versatile methodology for portfolio construction.

Furthermore, the paper presents real-life examples and backtests to illustrate the methodology. These examples include risk budgeting of the Fama-French equity factors, diversifying a hedge fund portfolio, and strategic asset allocation for pension funds facing liability constraints. The authors propose to replace the traditional regression approach with a risk contribution approach, which is more intuitive to portfolio managers. They also caution that portfolio construction is sensitive to the underlying risk factors, which may not always be stable over time.

The paper generalizes the risk parity approach to consider risk factors instead of assets, acknowledging that the problem becomes trickier as multiple solutions can exist. The authors propose formulating the diversification problem in terms of risk factors as an optimization program, providing a systematic and intuitive methodology for portfolio construction and risk budgeting.

Overall, the paper contributes to the literature on portfolio construction and risk management by offering a comprehensive framework for achieving diversification and managing risk through the consideration of risk factor contributions.