In what follows, we’ll show how dispersion can be used to examine the connection between active management performance and the idiosyncrasies present within underlying markets. We’ll also demonstrate other interesting uses of dispersion, which is well-suited to address questions regarding the importance of various risk factors and exposures. 

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The Best Offense: When Defensive Strategies Win

S&P Dow Jones Indices is out with a piece of research that highlight the regime conditional benefit of Low Volatility investing.

Understanding any investment strategy requires us to understand how its success is driven by the market regime in which it operates.

Strategies that overweight high beta stocks, e.g., will tend to look good in strong markets and bad in weak markets. Defensive strategies like low volatility or high yield will display the opposite pattern.

Epsilon Theory: It's Not About the Nail

Do, or do not. There is no try.”

– Yoda, “Star Wars: Episode V - The Empire Strikes Back” (1980)

I see it all perfectly; there are two possible situations - one can either do this or that. My honest opinion and my friendly advice is this: do it or do not do it - you will regret both.
– Soren Kierkegaard, "Either/Or: A Fragment of Life" (1843)

Allocating for Impact

I see several trends lining up, enabling Impact Investing to become a founding aspect on most investment portfolios and allocation frameworks.

  1. Traditional assets and their conditional correlations are increasingly converting.

  2. Society in general and sophisticated Investors specifically, are increasingly recognizing that Social Responsibility is not only public Sector issue

  3. Impact Investing has the potential to produce attractive and non-correlated returns.

The Name of the Rose

If names be not correct, language is not in accordance with the truth of things. 
– Confucius, “The Analects of Confucius” (551 - 479 BC)

Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. 
– Archimedes (287 - 212 BC)

You may be doing it wrong: A tale of two diversification strategies

The single greatest misperception we encounter with clients, and many advisors as well, is the idea that material diversification can be achieved with a large number of individual stocks or stock mutual funds. Not only is this untrue, but it’s less true now than ever because of high average stock correlations within and across markets.

Why allocating to negative expected excess return can be entirely rational

The vast majority of people will actually allocate, during their lifetime, to a strategy with negative expected excess return — and “happily” do so!  What is this strategy?  Insurance.  Why do we choose to allocate to such a strategy?  Risk aversion implies that we’ll take a small shift left in our return distribution for the non-linear tail protection afforded to us.

Risk Attribution in a Portfolio

Diversification is touted as the only free lunch (see our old post Is Diversification Really a Free Lunch) in investing and is a primary way to reduce portfolio volatility without sacrificing a proportional amount of return.  Return characteristics aside, a well-diversified portfolio can be less risky than any of the constituents taken alone; it is truly a case where the sum of the parts is greater than the whole.

Allocating for Impact

I see several trends lining up, enabling Impact Investing to become a founding aspect on most investment portfolios and allocation frameworks.

  1. Traditional assets and their conditional correlations are increasingly converting.

  2. Society in general and sophisticated Investors specifically, are increasingly recognizing that Social Responsibility is not only public Sector issue

  3. Impact Investing has the potential to produce attractive and non-correlated returns.

The Dude Abides: China in the Golden Age of Central Bankers

A compassionate man once caught a turtle. He wanted to make it into soup, but unwilling to be accused of taking life, he boiled a pan full of water and, placing a narrow rod over the pan, said to the turtle, “If you can get across the pan, I will set you free.”

The turtle was in no doubt as to the intentions of the man. But he did not want to die. So, summoning up all his will, he accomplished the impossible.

Embedding Diversification in Momentum Analysis

Portfolio engineering is certainly a place where the whole can be greater than the sum of the parts.  Historically, momentum has been a study of the parts with no real concern for how those parts are ultimately combined.  If we consider the most academic of methodologies – taking 1000 securities, ranking by trailing returns, and selecting a portfolio of the top N – we may ultimately end up with considerable concentration risk in our construction.

S&P Dow Jones Indices - InSIGHTS

Rethinking Risk: Are Managed Volatility Equity Strategies the Answer?

When it comes to portfolio risk management, investors may want to prepare for all types of volatility regimes.

A Market of Stocks
Is there a way to measure the degree to which a market environment is more or less conducive to successful stock selection?  

A New Year for Commodities?

Several factors present in global markets may signal an environment ready for commodities to rise to the surface.

"Smart Diversification"...

"Smart Diversification"? Smart Beta is receiving a lot of media attention and asset flow these days. But what about "Smart Diversification"? If smart beta strategies are alternatives to market-cap weightings, then what do you call strategies that seek to maintain diversification benefits when correlations are rising..."Smart Diversification"? As the BlackRock article below points out, diversification is difficult when correlations are rising. This is especially true for non-core exposures as advisors are sold them under the notion that they have a low correlation to core exposures.

Ossiam launch iSTOXX Europe Minimum Variance NR, 2C (EUR) Class

The investment objective of the Fund is to replicate, before the Fund’s fees and expenses, the performance of the iSTOXX® Europe Minimum Variance Index Net Return.

The aim of the Index is to deliver the net total return performance of a selection of stocks, from the STOXX® Europe 600 Index that are the most liquid and weighted to minimize the volatility of the total portfolio (optimal weights)

Regarding Correlation I urge members to read the research paper: Deceived by Correlations: A Quant Conundrum here

Capital Diversification versus Risk Diversification

In this blog post, we explore the implications of asset-class based diversification on risk management and demonstrate that traditional passive 60/40 portfolios may actually be much less diversified than we think. 

In Hedge Fund Market Wizards, Ray Dalio, founder of Bridgewater Associates, is quoted as saying,

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Dispersion: Measuring Market Opportunity

In what follows, we’ll show how dispersion can be used to examine the connection between active management performance and the idiosyncrasies present within underlying markets. We’ll also demonstrate other interesting uses of dispersion, which is well-suited to address questions regarding the importance of various risk factors and exposures. 

 

Evaluating New Methodologies in Asset and Risk Allocation

Risk parity strategies favor bonds over equities, but they do not necessarily outperform a static portfolio of 60% equity/40% bonds. Portfolio optimization is evolving beyond traditional Markowitz mean–variance optimiza- tion to incorporate the higher moments of skewness and kurtosis, which are applicable to alternative investments.

Correlation vs. Trends in Portfolio Management: A Common Misinterpretation

Abstract: Two common beliefs in finance are that (i) a high positive correlation signals assets moving in the same direction while a high negative correlation signals assets moving in opposite directions; and (ii) the mantra for diversification is to hold assets that are not highly correlated. We explain why both beliefs are not only factually incorrect, but can actually result in large losses in what are perceived to be well diversified portfolios. 

Christoph Kind: Risk-Based Allocation of Principal Portfolios

Risk-based asset allocation strategies are mainly used to diversify nominal asset weights. In this paper, we discuss the diversification of risk factors. The analysis is based on the idea of Partovi and Caputo (2004), who use principal component analysis to transform a portfolio into a set of uncorrelated principal portfolios. Risk-based asset allocation strategies can be applied to these uncorrelated sources of risk. A similar route has been taken by Meucci (2009) with his idea of a maximum entropy portfolio.

Lohre, Opfer, & Orszag: Diversifying Risk Parity

Striving for maximum diversification we follow Meucci (2009) in measuring and managing a multi-asset class portfolio. Under this paradigm the maximum diversification portfolio is equivalent to a risk parity strategy with respect to the uncorrelated risk sources embedded in the underlying portfolio assets. Our paper characterizes the mechanics and properties of this diversified risk parity strategy.

Attilio Meucci: Managing Diversification

We propose a unified, fully general methodology to analyze and act on diversification in any environment, including long-short trades in highly correlated markets with complex derivatives. First, we build the diversification distribution, i.e. the distribution of the uncorrelated bets in the portfolio that are consistent with the portfolio constraints. Next, we summarize the wealth of information provided by the diversification distribution into one single diversi- fication index, the effective number of bets, based on the entropy of the diversi- fication distribution.

Roncalli & Weisang: Risk Parity Portfolios with Risk Factors

Portfolio construction and risk budgeting are the focus of many studies by academics and practitioners. In particular, diversification has spawn much interest and has been defined very differently. In this paper, we analyze a method to achieve portfolio diversification based on the decomposition of the portfolio's risk into risk factor contributions. First, we expose the relationship between risk factor and asset contributions. Secondly, we formulate the diversification problem in terms of risk factors as an optimization program.

Bhansali, Davis, Rennison, Hsu & Li: The Risk in Risk Parity

To sum-up the paper the authors basically illustrate how traditional Asset Allocation and first generation Risk Parity models are broken, because while they may be diversified across Assets, they are concentrated around the same return drivers. 

The authors use a Principal Component Analysis showing that exposure are basically driven by two eigenvalues, that they proxy as Global Growth and Global Inflation. 

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