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Adaptive Optimal Risk Budgeting

Alexander Rudin, Vikas Mor and Daniel Farley
The Journal of Portfolio Management Multi-Asset Special Issue 2020, 46 (6) 147-158; DOI: https://doi.org/10.3905/jpm.2020.1.148
Alexander Rudin
is a managing director of investment solutions at State Street Global Advisors in Boston, MA
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Vikas Mor
is a senior associate for investment solutions at State Street Global Advisors in Bangalore, India
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Daniel Farley
is chief investment officer of investment solutions at State Street Global Advisors in Boston, MA
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Abstract

In this article, the authors suggest Bayesian-style adaptive enhancement to a popular equal risk contribution (ERC) portfolio construction technique they call adaptive optimal risk budgeting (AORB). The enhancement has the potential to bring portfolios closer to mean–variance efficiency when Sharpe ratios and correlations of assets vary while retaining some of the ERC’s robustness to estimation errors. The authors test AORB’s viability by putting it in competition with ERC itself and with a version of the Bayesian shrinkage mean–variance technique in a carefully simulated setting. They find that the new method appears to deliver measurable advantages over its competition in a broad range of realistic settings. Multiple possible applications to portfolios of risk premia strategies and a multi-asset universe more generally are discussed by the authors.

TOPICS: Portfolio construction, analysis of individual factors/risk premia

Key Findings

  • • We suggested a computationally simple yet powerful portfolio construction approach that is formulated in terms of risk contributions but is designed to prescribe an approximately mean-variance efficient solution even when Sharpe ratios and correlations between assets vary in magnitude and over time. We called the new method Adaptive Optimal Risk Budgeting (AORB).

  • • When tested against popular Equal Risk Contributions and “classical” Bayesian shrinkage methods, AORB was competitive in all cases and emerged as a clear winner when Sharpe ratios and correlations between assets were substantially differentiated.

  • • AORB can also be trivially expanded to incorporate tail risk considerations.

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The Journal of Portfolio Management: 46 (6)
The Journal of Portfolio Management
Vol. 46, Issue 6
Multi-Asset Special Issue 2020
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Adaptive Optimal Risk Budgeting
Alexander Rudin, Vikas Mor, Daniel Farley
The Journal of Portfolio Management May 2020, 46 (6) 147-158; DOI: 10.3905/jpm.2020.1.148

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Adaptive Optimal Risk Budgeting
Alexander Rudin, Vikas Mor, Daniel Farley
The Journal of Portfolio Management May 2020, 46 (6) 147-158; DOI: 10.3905/jpm.2020.1.148
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  • Article
    • Abstract
    • PORTFOLIO CONSTRUCTION THREE WAYS
    • DESIGNING TESTING FRAMEWORK
    • RESULTS OF NUMERICAL EXPERIMENTS
    • AORB AND TAIL RISK MANAGEMENT
    • CONCLUDING REMARKS
    • ADDITIONAL READING
    • ACKNOWLEDGMENT
    • APPENDIX
    • ENDNOTES
    • REFERENCES
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