Taking the right course navigating the ERC universe

Abstract

We study the equal risk contribution (ERC) investment strategies exploring how these portfolios perform relative to traditional risk-only (minimum variance portfolio), risk–return (Markowitz portfolio) and naive (1/n) investment schemes when expanding the asset class universe. We propose a combinatorial mechanism to expand the investment universe of all feasible ERC portfolios and then combine them, thus realizing an ERC efficient frontier consistent with the mutual fund separation theorem (Merton in J Financ Quant Anal 7:1851–1872, 1972). In doing this, we mitigate the out-of-sample estimation error in portfolio weights and better diversify asset allocation against unpredictable extreme events. Simulation, bootstrapping and empirical experiments indicate that the corresponding tangency portfolio, computed through the regression-based approach introduced in Britten-Jones (J Finance 54:655–671, 1999), offers better risk-adjusted performance relative to risk-only, risk–return-based competitors as well as the 1/n strategy.