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Second-order risk of alternative risk parity strategies

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Second-order risk of alternative risk parity strategies. / Bernardi, Simone; Leippold, Markus; Lohre, Harald.

In: Journal of Risk, Vol. 21, No. 3, 28.02.2019, p. 1-25.

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Bernardi, S, Leippold, M & Lohre, H 2019, 'Second-order risk of alternative risk parity strategies', Journal of Risk, vol. 21, no. 3, pp. 1-25. https://doi.org/10.21314/JOR.2018.401

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Bernardi, Simone ; Leippold, Markus ; Lohre, Harald. / Second-order risk of alternative risk parity strategies. In: Journal of Risk. 2019 ; Vol. 21, No. 3. pp. 1-25.

Bibtex

@article{42dc8f9afd164d0cac11c48e975f016c,
title = "Second-order risk of alternative risk parity strategies",
abstract = "The concept of second-order risk operationalizes the estimation risk induced by model uncertainty in portfolio construction. We study its contribution to the realized volatility of recently developed alternative risk parity strategies that invest in an uncorrelated decomposition of the asset universe. For each strategy, we derive closed-form solutions for the second-order risk, subsequently illustrated in empirical analysis based on real market data. Our results suggest a relation between the contribution of second-order risk and the sensitivity of a portfolio to single eigenvectors of the covariance matrix of assets{\textquoteright} returns. Among the strategies considered, we find the principal risk parity strategy that invests equally in each eigenvector underlying the variance-covariance matrix to be immune to second-order risk. For the other strategies, second-order risk can be partially mitigated by means of statistical methods. In particular, we provide evidence for the eigenvalue adjustment being the most effective method for correcting the second-order risk bias.",
keywords = "Diversification, Estimation risk, Portfolio construction, Risk parity, Second-order risk",
author = "Simone Bernardi and Markus Leippold and Harald Lohre",
year = "2019",
month = feb,
day = "28",
doi = "10.21314/JOR.2018.401",
language = "English",
volume = "21",
pages = "1--25",
journal = "Journal of Risk",
issn = "1465-1211",
publisher = "Incisive Media Ltd.",
number = "3",

}

RIS

TY - JOUR

T1 - Second-order risk of alternative risk parity strategies

AU - Bernardi, Simone

AU - Leippold, Markus

AU - Lohre, Harald

PY - 2019/2/28

Y1 - 2019/2/28

N2 - The concept of second-order risk operationalizes the estimation risk induced by model uncertainty in portfolio construction. We study its contribution to the realized volatility of recently developed alternative risk parity strategies that invest in an uncorrelated decomposition of the asset universe. For each strategy, we derive closed-form solutions for the second-order risk, subsequently illustrated in empirical analysis based on real market data. Our results suggest a relation between the contribution of second-order risk and the sensitivity of a portfolio to single eigenvectors of the covariance matrix of assets’ returns. Among the strategies considered, we find the principal risk parity strategy that invests equally in each eigenvector underlying the variance-covariance matrix to be immune to second-order risk. For the other strategies, second-order risk can be partially mitigated by means of statistical methods. In particular, we provide evidence for the eigenvalue adjustment being the most effective method for correcting the second-order risk bias.

AB - The concept of second-order risk operationalizes the estimation risk induced by model uncertainty in portfolio construction. We study its contribution to the realized volatility of recently developed alternative risk parity strategies that invest in an uncorrelated decomposition of the asset universe. For each strategy, we derive closed-form solutions for the second-order risk, subsequently illustrated in empirical analysis based on real market data. Our results suggest a relation between the contribution of second-order risk and the sensitivity of a portfolio to single eigenvectors of the covariance matrix of assets’ returns. Among the strategies considered, we find the principal risk parity strategy that invests equally in each eigenvector underlying the variance-covariance matrix to be immune to second-order risk. For the other strategies, second-order risk can be partially mitigated by means of statistical methods. In particular, we provide evidence for the eigenvalue adjustment being the most effective method for correcting the second-order risk bias.

KW - Diversification

KW - Estimation risk

KW - Portfolio construction

KW - Risk parity

KW - Second-order risk

U2 - 10.21314/JOR.2018.401

DO - 10.21314/JOR.2018.401

M3 - Journal article

AN - SCOPUS:85067942198

VL - 21

SP - 1

EP - 25

JO - Journal of Risk

JF - Journal of Risk

SN - 1465-1211

IS - 3

ER -