Horizon Diversification: Reducing Risk in a Portfolio of Active Strategies

Abstract

A primary mechanism for controlling portfolio risk is diversification. Diversification is typically addressed by distributing assets among investment sectors and issuers, preferably with low correlations among their returns, a process that can be called asset diversification. The risk reduction from this type of diversification can be less than expected in the midst of a crisis as correlations increase across market segments. The authors of this article consider a new approach to managing the active risk profile of a portfolio, an approach that uses active strategies rather than asset allocations as its basic building blocks. The authors show that in this framework, risk reduction is achieved by a combination of two distinct mechanisms—asset diversification and signal diversification. Combining alpha strategies based on independent signals can help reduce portfolio risk, even when the returns of the underlying assets are correlated. One way to achieve signal diversification is by combining strategies with various investment horizons or trading frequencies—a technique the authors call horizon diversification. Horizon diversification is an intuitive and robust way to decrease risk in a portfolio of active strategies.

TOPICS: Portfolio construction, VAR and use of alternative risk measures of trading risk, analysis of individual factors/risk premia