Abstract
In order to build a low-risk Fund of Funds (FOF), from the perspective of correlation, the principal component factor is used to improve the traditional risk parity model. Principal component analysis is used to decompose the underlying assets and generate unrelated principal component factors, and then the authors can construct a principal component risk parity portfolio. The proposed empirical results based on China’s mutual fund market show that the performance of principal component risk parity portfolio (PCRPP) is better than that of equal weight portfolio (EWP) and traditional risk parity portfolio (RPP). That is to say, not only the PCRPP in this paper has much lower risk than EWP and RPP, but also slightly better than EWP and RPP in terms of average return. Moreover, the study of dividing the underlying assets shows that the PCRPP in this paper is not sensitive to the underlying assets. The PCRPP in this paper is better than EWP and RPP for both the better performing funds and the worse performing funds. In addition, the empirical results on dynamic portfolio adjustments show that it is not appropriate to adjust asset allocation too frequently when the expected rate of return is calculated using the arithmetic mean.
Similar content being viewed by others
References
Lohre H, Opfer H, and Orszag G, Diversifying risk parity, Journal of Risk, 2014, 16: 53–79.
Qian E, Risk parity portfolios: Efficient portfolios through true diversification, Boston, Panagora Asset Management, 2005.
Deguest R, Martellini L, and Meucci A, Risk parity and beyond-from asset allocation to risk allocation decisions, 2013, DOI: https://doi.org/10.2139/ssrn.2355778.
Erling M and Mllenhoff S, Factor risk parity with portfolio weight constraints, 2016, DOI: https://doi.org/10.2139/ssrn.2615695.
Partovi M H and Caputo M, Principal portfolios: Recasting the efficient frontier, Economics Bulletin, 2004, 7: 1–10.
Markowitz H, Portfolio selection, Journal of Finance, 1952, 7: 77–91.
Mao J C, Models of capital budgeting, E-V vs E-S, Journal of Financial and Quantitative Analysis, 1970, 4: 657–675.
Clarke R G, De Silva H, and Thorley S, Minimum-variance portfolios in the U.S. equity market, The Journal of Portfolio Management, 2006, 33: 10–24.
Qin N and Wang Y, Does portfolio concentration affect performance? Evidence from corporate bond mutual funds, Journal of Banking & Finance, 2021, 123: 106033.
Roman D and Mitra G, Portfolio selection models: A review and new directions, Journal of Innovative Quantitative Finance Research, 2009, 1: 69–85.
Avramov D and Zhou G, Bayesian portfolio analysis, Annual Review of Financial Economics, 2010, 2: 25–47.
Evans J L and Archer S H, Diversification and the reduction of dispersion: An empirical analysis, The Journal of Finance, 1968, 23: 761–767.
Choueifaty Y and Coignard Y, Toward maximum diversification, The Journal of Portfolio Management, 2008, 35: 40–51.
Li H L, Huang Q, and Wu B Y, Improving the naive diversification: An enhanced indexation approach, Finance Research Letters, 2021, 39: 101661.
Bera A K and Park S Y, Optimal portfolio diversification using the maximum entropy principle, Econometric Reviews, 2008, 27: 484–512.
Pola G, On entropy and portfolio diversification, Journal of Asset Management, 2016, 17: 218–228.
Yue W and Wang Y P, A new fuzzy multi-objective higher order moment portfolio selection model for diversified portfolios, Physica A: Statistical Mechanics and Its Applications, 2017, 465: 124–140.
Desmoulins-Lebeault F and Kharoubi-Rakotomalala C, Non-Gaussian diversification: When size matters, Journal of Banking & Finance, 2012, 36(7): 1987–1996.
Brandtner M, Conditional value-at-risk, spectral risk measures and (non-)diversification in portfolio selection problems — A comparison with mean-variance analysis, Journal of Banking & Finance, 2013, 37(12): 5526–5537.
Eom C, Kaizoji T, Livan G, et al., Limitations of portfolio diversification through fat tails of the return distributions: Some empirical evidence, The North American Journal of Economics and Finance, 2021, 56: 101358.
Maillard S, Roncalli T, Teïletche J, The properties of equally weighted risk contribution portfolios, The Journal of Portfolio Management, 2010, 36(4): 60–70.
Qian E, Risk parity and diversification, The Journal of Investing, 2011, 20: 119–127.
Bhansali V, Davis J, Rennison G, et al., The risk in risk parity: A factor-based analysis of asset-based risk parity, The Journal of Investing, 2012, 21: 102–110.
Boudt K and Peeters B, Asset allocation with risk factors, Quantitative Finance, 2013, 1: 60–65.
Kaucic M, Equity portfolio management with cardinality constraints and risk parity control using multi-objective particle swarm optimization, Computers & Operations Research, 2019, 109: 300–316.
Shimizu H and Shiohama T, Constructing inverse factor volatility portfolios: A risk-based asset allocation for factor investing, International Review of Financial Analysis, 2020, 68: 101438.
Wu L L, Feng Y Y, and Palomar D P, General sparse risk parity portfolio design via successive convex optimization, Signal Processing, 2020, 170: 107433.
Bellini F, Cesarone F, Colombo C, et al., Risk parity with expectiles, European Journal of Operational Research, 2021, 291(3): 1149–1163.
Ang A and Chen J, Symmetric correlations of equity portfolios, Journal of Financial Economics, 2002, 63(3): 443–494.
Varga-Haszonits I and Kondor I, Noise sensitivity of portfolio selection in constant conditional correlation GARCH models, Physica A: Statistical Mechanics and Its Applications, 2007, 385(1): 307–318.
Aslanidis N and Casas I, Nonparametric correlation models for portfolio allocation, Journal of Banking & Finance, 2013, 37(7): 2268–2283.
Sun X L and Liu Z X, Optimal portfolio strategy with cross-correlation matrix composed by DCCA coefficients: Evidence from the Chinese stock market, Physica A: Statistical Mechanics and Its Applications, 2016, 444: 667–679.
Eom C and Park J W, Effects of common factors on stock correlation networks and portfolio diversification, International Review of Financial Analysis, 2017, 49: 1–11.
Eom C and Park J W, A new method for better portfolio investment: A case of the Korean stock market, Pacific-Basin Finance Journal, 2018, 49: 213–231.
Gokmenoglu K K and Hadood AAA, Impact of US unconventional monetary policy on dynamic stock-bond correlations: Portfolio rebalancing and signalling channel effects, Finance Research Letters, 2020, 33: 101185.
Joo Y C and Park S Y, Optimal portfolio selection using a simple double-shrinkage selection rule, Finance Research Letters, 2021, 43: 102019.
Li J, Wu X, Zhang L L, et al., Research on the portfolio model based on mean-MF-DCCA under multifractal feature constraint, Journal of Computational and Applied Mathematics, 2021, 386: 113264.
Takano Y and Gotoh J, Multi-period portfolio selection using kernel-based control policy with dimensionality reduction, Expert Systems with Applications, 2014, 41(8): 3901–3914.
Tayali H A and Tolun S, Dimension reduction in mean-variance portfolio optimization, Expert Systems with Applications, 2018, 92: 161–169.
Nobre J and Neves R F, Combining principal component analysis, discrete wavelet transform and XGBoost to trade in the financial markets, Expert Systems with Applications, 2019, 125: 181–94.
Paolella M S, Polak P, and Walker P S, A non-elliptical orthogonal GARCH model for portfolio selection under transaction costs, Journal of Banking & Finance, 2021, 125: 106046.
Nakano M and Takahashi A, A new investment method with AutoEncoder: Applications to crypto currencies, Expert Systems with Applications, 2020, 162: 113730.
Lassance N and Vrins F, Portfolio selection with parsimonious higher comoments estimation, Journal of Banking & Finance, 2021, 126: 106115.
Roncalli T and Weisang G, Risk parity portfolios with risk factors, Quantitative Finance, 2016, 16: 377–388.
Meucci A, Santangelo A, and Deguest R, Risk budgeting and diversification based on optimized uncorrelated factors, 2015, DOI: https://doi.org/10.2139/ssrn.2276632.
Bai X, Scheinberg K, and Tutuncu R, Least-squares approach to risk parity in portfolio selection, Quantitative Finance, 2016, 16(3): 357–376.
Bruder B and Roncalli T, Managing risk exposures using the risk budgeting approach, 2012, DOI: https://doi.org/10.2139/ssrn.2009778.
Baitinger E, Dragosch A, and Topalova A, Extending the risk parity approach to higher moments: Is there any value added? The Journal of Portfolio Management, 2017, 43: 24–36.
Cesarone F and Tardella F, Equal risk bounding is better than risk parity for portfolio selection, Journal of Global Optimization, 2017, 68: 439–461.
Blocher J, Haslag P, and Zhang C, Short trading and short investing, Journal of Empirical Finance, 2020, 59: 154–171.
Ghosh P, Neufeld A, and Sahoo J K, Forecasting directional movements of stock prices for intraday trading using LSTM and random forests, 2022, 46: 102280.
Sermpinis G, Laws J, and Dunis C L, Modelling and trading the realised volatility of the FTSE100 futures with higher order neural networks, The European Journal of Finance, 2013, 19(3): 165–179.
Brzeszczyáski J, Gajdka J, and Schabek T, The role of stock size and trading intensity in the magnitude of the “interval effect” in beta estimation: Empirical evidence from the polish capital market, Emerging Markets Finance and Trade, 2011, 47(1): 28–49.
Chaves D, Hsu J, Li F, et al., Risk parity portfolio vs. other asset allocation heuristic portfolios, The Journal of Investing, 2011, 20: 108–118.
Author information
Authors and Affiliations
Corresponding authors
Ethics declarations
The authors declare no conflict of interest.
Additional information
This research was supported by the Chinese National Science Foundation under Grant Nos. U1811462, 71771116, the Ministry of Education, Late-stage Subsidy Project for Philosophical and Social Sciences Research Foundation under Grant No. 18JHQ058.
Rights and permissions
About this article
Cite this article
Bai, W., Zhang, J., Liu, H. et al. How to Construct a Lower Risk FOF Based on Correlation Network? The Method of Principal Component Risk Parity Asset Allocation. J Syst Sci Complex 37, 1052–1079 (2024). https://doi.org/10.1007/s11424-023-2296-4
Received:
Revised:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11424-023-2296-4