Demystifying Equity Risk–Based Strategies: A Simple Alpha plus Beta Description

Abstract

In this article, de Carvalho, Lu, and Moulin consider five risk-based strategies: equally weighted, equal-risk budget, equal-risk contribution, minimum variance, and maximum diversification. All five strategies can be well described by exposure to the market-cap index and to four simple factors: low beta, small cap, low residual volatility, and value. This finding, in their view, is a major contribution to the understanding of such strategies and provides a simple framework to compare them. All except the equal-weighted strategy are defensive and have lower volatility than the market-cap index. Equal-weighted is exposed to small-cap stocks. Equal-risk budget and equal-risk contribution are exposed to small-cap and to low-beta stocks. These three have a high correlation of excess returns, and their portfolios largely overlap. Their portfolios invest in all stocks available and have both a low turnover and low tracking error relative to the market-cap index. The minimum variance and maximum diversification strategies primarily have exposure to low-beta stocks. These two strategies are the most defensive, invest in much the same stocks, and have high tracking error and turnover. TOPICS:Volatility measures, VAR and use of alternative risk measures of trading risk, analysis of individual factors/risk premia

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