An integrated risk-budgeting approach for multi-strategy equity portfolios

The authors propose a robust optimisation approach to construct realistic constrained multi-strategy portfolios that starts with the identification of different sources of excess returns and the risk-budgeting exercise to optimally combine them. They show how systematic factor strategies can be combined with judgemental strategies and how bottom-up-based strategies for stock picking can be combined with top-down sector or country allocation strategies. The approach is fully transparent for both unconstrained and constrained portfolios. In particular, it is shown that constrained portfolios retain the exposures to systematic risks factors in the unconstrained target solution as much as possible, and that specific risk takes the toll of portfolio constraints. A realistic back-tested example combining four different well-known factor strategies – value, momentum, low risk and size – demonstrates the robustness and transparency of the approach. The advantages of the approach over the alternative process based on selecting and investing in a mix of different index funds implementing off-the-shelf active strategies is highlighted. The authors find their approach particularly suited for institutional investors interested in fully controlling the active risk budget allocation to factor strategies in their portfolios while fully understanding the final allocation in their constrained portfolios.