Risk Parity Portfolios with Risk Factors

Portfolio construction and risk budgeting are the focus of many studies by academics and practitioners. In particular, diversification has spawn much interest and has been defined very differently. In this paper, we analyze a method to achieve portfolio diversification based on the decomposition of the portfolio's risk into risk factor contributions. First, we expose the relationship between risk factor and asset contributions. Secondly, we formulate the diversification problem in terms of risk factors as an optimization program. Finally, we illustrate our methodology with some real life examples and backtests, which are: budgeting the risk of Fama-French equity factors, maximizing the diversification of an hedge fund portfolio and building a strategic asset allocation based on economic factors.