Risk Return Trade-Off in Relaxed Risk Parity Portfolio Optimization

Vaughn Gambeta and Roy Kwon
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Vaughn Gambeta: Department of Mechanical and Industrial Engineering, University of Toronto, 5 King’s College Rd, Toronto, ON M5S 3G8, Canada
Roy Kwon: Department of Mechanical and Industrial Engineering, University of Toronto, 5 King’s College Rd, Toronto, ON M5S 3G8, Canada

JRFM, 2020, vol. 13, issue 10, 1-28

Abstract: This paper formulates a relaxed risk parity optimization model to control the balance of risk parity violation against the total portfolio performance. Risk parity has been criticized as being overly conservative and it is improved by re-introducing the asset expected returns into the model and permitting the portfolio to violate the risk parity condition. This paper proposes the incorporation of an explicit target return goal with an intuitive target return approach into a second-order-cone model of a risk parity optimization. When the target return is greater than risk parity return, a violation to risk parity allocations occurs that is controlled using a computational construct to obtain near-risk parity portfolios to retain as much risk parity-like traits as possible. This model is used to demonstrate empirically that higher returns can be achieved than risk parity without the risk contributions deviating dramatically from the risk parity allocations. Furthermore, this study reveals that the relaxed risk parity model exhibits advantageous traits of robustness to expected returns, which should not deter the use of expected returns in risk parity model.

Keywords: portfolio optimization; risk parity; equal-risk budget; relaxation; asset allocation; marginal risk contribution; robust optimization; Markowitz; risk-based; robust (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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