Network Risk Parity: graph theory-based portfolio construction

Vito Ciciretti () and Alberto Pallotta ()
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Alberto Pallotta: Middlesex University

Journal of Asset Management, 2024, vol. 25, issue 2, No 2, 136-146

Abstract: Abstract This study presents network risk parity, a graph theory-based portfolio construction methodology that arises from a thoughtful critique of the clustering-based approach used by hierarchical risk parity. Advantages of network risk parity include: the ability to capture one-to-many relationships between securities, overcoming the one-to-one limitation; the capacity to leverage the mathematics of graph theory, which enables us, among other things, to demonstrate that the resulting portfolios is less concentrated than those obtained with mean-variance; and the ability to simplify the model specification by eliminating the dependency on the selection of a distance and linkage function. Performance-wise, due to a better representation of systematic risk within the minimum spanning tree, network risk parity outperforms hierarchical risk parity and other competing methods, especially as the number of portfolio constituents increases.

Keywords: Portfolio construction; Graph theory; Hierarchical clustering; Eigenvalues (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1057/s41260-023-00347-8

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