Specifying and Managing Tail Risk in Multi-Asset Portfolios -- A Summary

Abstract

Constructing a multi-asset portfolio with a constraint of tail risk aversion is challenging because (1) the individual asset classes have poor tail risk characteristics and (2) diversification between asset classes is minimal. A better portfolio can be achieved using a multi-strategy framework for the allocation process, whereby different methods of asset and risk allocation co-exist as independent strategies within the same portfolio. This framework creates strategy diversification, allows allocation to be done at multiple investment horizons, and helps to manage tail risk of the portfolio.Conventional tail risk measures, which use only the end-of-horizon return distribution, fail to capture the real risk that an asset owner has of intra-horizon drawdown. Thus, a tail risk measure that is a composite of intra-horizon and end-of-horizon risk should lead to a portfolio with fewer unexpected outcomes. Finally, a better and more aligned portfolio is created if intra-horizon risk is incorporated into the portfolio construction process, the investment horizon of each asset in the portfolio is chosen, and customized stop-loss levels are implemented at the asset level.