A constrained hierarchical risk parity algorithm with cluster-based capital allocation

Johann Pfitzinger () and Nico Katzke ()
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Johann Pfitzinger: Department of Economics, Stellenbosch University
Nico Katzke: Department of Economics, Stellenbosch University & Prescient Securities, Cape Town

No 14/2019, Working Papers from Stellenbosch University, Department of Economics

Abstract: Hierarchical Risk Parity (HRP) is a risk-based portfolio optimisation algorithm, which has been shown to generate diversified portfolios with robust out-of-sample properties without the need for a positive-definite return covariance matrix (Lopez de Prado 2016). The algorithm applies machine learning techniques to identify the underlying hierarchical correlation structure of the portfolio, allowing clusters of similar assets to compete for capital. The resulting allocation is both well-diversified over risk sources and intuitively appealing. This paper proposes a method of fully exploiting the information created by the clustering process, achieving enhanced out-of-sample risk and return characteristics. In addition, a practical approach to calculating HRP weights under box and group constraints is introduced. A comprehensive set of portfolio simulations over 6 equity universes demonstrates the appeal of the algorithm for portfolios consisting of 20 - 200 assets. HRP delivers highly diversified allocations with low volatility, low portfolio turnover and competitive performance metrics.

Keywords: Risk Parity; Diversification; Portfolio Optimisation; Clustering (search for similar items in EconPapers)
JEL-codes: G11 (search for similar items in EconPapers)
Date: 2019
New Economics Papers: this item is included in nep-cmp, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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