Risk budgeting using a generalized diversity index

Uniform budgeting in risk budgeting (RB), which results in risk parity (RP), can be sub-optimal in the case where assets are correlated. In particular, it may lead to solutions with factor risk concentration when asset correlations are high. For that reason, RP based on uncorrelated or independent risk factors, called factor risk parity (FRP), was suggested. Despite its attractiveness, FRP has some significant empirical and theoretical drawbacks. In this paper, drawing on the literature on diversity measures in ecology, we argue for an alternative way of thinking about risk contribution diversification in the presence of correlated assets. We propose a new risk contribution diversification approach based on Leinster and Cobbold’s (Ecology 93:477–489, 2012) diversity index. We show that this approach is an RB approach, generalizing the RP approach, in which the budgets are endogenously determined by the similarity between assets. We evaluate its empirical performance against a range of portfolio diversification approaches, including RP, among others. Our findings show that our RB approach is a promising alternative to the RP approach.