Dynamic Risk-Based Asset Allocation

Abstract

In asset allocation, the equal risk contribution (ERC) approach has rapidly gained 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 subportfolio is allocated based on market capitalization weights, the ERC portfolio allocation tends to be 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 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 of replacing the market capitalization-weighted equity index with a low-risk equity index. The second suggestion to increase the equity allocation is to deviate from an equal risk contribution objective to a 60/40 risk allocation strategy. We show that 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.