Various risk parity methodologies are a popular choice for the construction of better diversified and balanced portfolios. It is notoriously hard to predict the future performance of the majority of asset classes. Risk parity approach overcomes this shortcoming by building portfolios using only assets’ risk characteristics and correlation matrix. A new research paper written by Lohre, Rother and Schafer builds on the foundation of classical risk parity methods and presents hierarchical risk parity technique. Their method uses graph theory and machine learning to build a hierarchical structure of the investment universe. Such structure allows better division of assets into clusters with similar characteristics without relying on classical correlation analysis. These portfolios then offer better tail risk management, especially for skewed assets and style factor strategies.
Authors: Lohre, Rother and Schafer
Title: Hierarchical Risk Parity: Accounting for Tail Dependencies in Multi-Asset Multi-Factor Allocations