Final published version
Research output: Contribution to Journal/Magazine › Journal article › peer-review
Research output: Contribution to Journal/Magazine › Journal article › peer-review
}
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 -