Tuesday, February 24, 2009

Diversification Across Risk Premiums

Things have been crazy lately - we have two speakers this week at Unknown University's College of Business, and I'm involved in both visits. In addition, I'm getting ready for my CFA prep class and trying to get a paper out for a conference. So, blogging has been light this week (and will probably continue to be spotty for the rest of the week).

But in the meantime, here's an interesting paper to chew on. We were recently talking about different risk premia (size, market/book, momentum, etc...) in class. This paper, "Portfolio of Risk Premia: A New Approach to Diversification" by Remy Brian, Frank Nielsen, and Dan Stefek paper that takes the idea of risk premia combines it with a equally-weighted portfolio weighting scheme across assets with exposures to the various premiums.
Traditional approaches of structuring policy portfolios for strategic asset allocation have not provided the full potential of diversification. Portfolios based upon a 60/40 allocation between equities and bonds remain volatile and dominated by equity risk. In this paper, we introduce a different approach to portfolio diversification. This approach looks at structuring portfolios using available risk premia within the traditional asset classes or from systematic trading strategies rather than focusing on classic betas such as equities and bonds. We start by reviewing the various ways of dissecting asset classes into their underlying systematic drivers or risk premia and analyze the historical risk and return patterns for a number of risk premia across asset classes. In a second stage, we illustrate empirically that correlations between risk premia have been low, offering significant diversification potential. We then confirm the benefits of diversification with a simple asset allocation case study by comparing a typical 60/40 equity/fixed income allocation with an equal weighted allocation across eleven style and strategy risk premia. From 1995 to 2008, this simple combination had returns similar to the traditional allocation but with 65% less volatility.
You can read the whole thing on SSRN here