FINVEX White Paper on Dynamic Risk-Based Asset Allocation

By Kris Boudt, Joakim Darras & Benedict Peeters (Partners, Finvex Group)

We are seeing a shift in the investment paradigm from return-based to risk-based portfolio allocation. In asset allocation, the equal risk contribution (ERC) approach gains rapidly in popularity: portfolio weights are dynamically set such that the asset classes contribute equally to the portfolio risk. As such, the portfolio loads automatically less on the more risky asset and, by diversifying across asset classes, portfolio drawdowns are reduced.

When the equity sub-portfolio is allocated based on market capitalization weights, the ERC portfolio allocation tends to by dominated by the bond allocation. While the resulting portfolio has a low risk, it is in today’s market regime of low interest rates, also characterized by only moderate expected returns. For this reason, American fund managers have advocated to overlay the ERC portfolio with leverage.  Such a leveraged risk-diversified portfolio is commonly referred to as a risk-parity strategy. 

This white paper explores two leverage-free alternatives to increase tactically the equity allocation and preserve a completely risk-based asset allocation approach, which dynamically adjusts to the changing risk regimes.

The first one consists in replacing the market capitalization weighted equity index with a low risk equity index. In fact, in equity world, a low risk objective seems to emerge as the dominant approach in risk-based portfolio allocation. This trend is supported by a whole stream of recent theoretical and empirical research showing that particular features in the return distribution underpin the so-called “low volatility anomaly” that risk optimised portfolios deliver higher risk-adjusted returns than market capitalization weighted indices.

The second suggestion to increase the equity allocation is to deviate from an equal risk contribution objective to a 60/40 risk allocation strategy. In contrast to the 60/40 constant mix portfolio, the 60/40 risk allocation portfolio reacts to changes in the relative risk by automatically downweighting the more risky asset and has therefore still a low overall risk.

These two modifications increase significantly the weight of the equity portion in the portfolio, while still keeping the total risk of the dynamically rebalanced portfolios at a low level. 

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