Agnostic Allocation Portfolios: A Sweet Spot in the Risk-Based Jungle?

Abstract

The authors advocate the use of agnostic allocation for the construction of long-only portfolios of stocks. Agnostic allocation portfolios (AAPs) are a special member of a family of risk-based portfolios that are able to mitigate certain extreme features (excess concentration, high turnover, strong exposure to low-risk factors) of classic portfolio construction methods, while achieving similar performance. AAPs thus represent a very attractive alternative risk-based portfolio construction framework that can be implemented in different situations, with or without an active trading signal.

TOPICS: Portfolio theory, portfolio construction, risk management

Key Findings

• • Long-only risk-based portfolio construction methods that rely on the inverse covariance matrix, such as minimum variance and maximum diversification, are plagued by overconcentration, excess turnover, and exposure to the low-risk factor.

• • Agnostic allocation portfolios (AAPs) deliver a compromise between risk-based portfolios that are structurally blind to the correlation structure and those that invert the covariance matrix of returns. They significantly reduce turnover and concentration and achieve performance similar to or better than that of traditional methods.

• • AAPs are supplemented with a pruning technique that discards unnecessary exposures to low-significance statistical factors. This technique, combined with the use of adequately cleaned covariance matrices, improves the outcome of AAPs by further reducing excess trading and concentration.