Asset allocation with risk factors

Abstract

In this paper, we propose to build portfolios that offer diversification over so-called ‘risk factors’ and this within a minimum variance portfolio construction framework. We believe this approach is an important advancement compared with traditional asset allocation as it achieves a higher level of true risk diversification, taking into account the common and unique risk factors that each asset class is exposed to. We apply the methodology to a portfolio invested in European government bonds, corporate bonds, high-yield bonds and equity. The first application consists of an ex post factor risk contribution analysis where we decompose the portfolio risk into the risk associated with the economic activity, inflation, interest rate, exchange rate, credit risk, market risk and idiosyncratic asset class-specific risk factors. In the second application, we construct minimum variance portfolios that satisfy ex ante constraints on the factor risk contributions.