Portfolio optimization with respect to risk diversification

Dr. Thomas Neukirch1, November 2008

Abstract: Traditional portfolio optimization approaches suffer from the drawback of

often leading to highly concentrated portfolios. We propose a new kind of
optimization focusing on a homogeneous distribution of risk among the portfolio
constituents. We describe the underlying ideas of the approach and propose an easy to
use and intuitive implementation using volatility or downside volatility as risk
together with suitable homogeneity measures. The attractiveness of the approach lies
in the fact, that it can be used in the presence of constraints and that it leads to better
diversified portfolios without the need of manual adjustments. The diversifying effect
is illustrated by some asset allocation examples.

1. Introduction

Traditional portfolio optimization approaches like Markowitz’ mean variance optimization,

[Markowitz, 1952], and also more general approaches using risk measures such as downside
risk [Hogan and Warren, 1972] or including higher moments often lead to highly concentrated
portfolios. These, by construction, tend to pile into the constituents with the best return-risk-
characteristics as used by the optimizer.

In portfolio construction, one way to overcome such difficulties is the “equal weighting”
approach. It is nowadays widely used in enhanced indexing and has successfully entered the
ETF industry. On the level of asset allocation, naïve diversification seems to be a promising
approach due to rebalancing effects and since it does not need return or volatility forecasts. In
this sense, equal weighting is a kind of error minimization. On the level of equity portfolios,
[Treynor, 2005] gave a rationale, why equal weighted indices can be expected to outperform
their capitalization weighted analogue.

In [Neukirch, 2008], we analyzed the effects from using various kinds of alternative
weighting schemes applied to the MSCI World Index and found significant additional return.
In that analysis, we inter alia introduced the concept of “equal risk weighting”, which simply
meant to allocate so that all constituents contribute the same amount of risk to the overall
portfolio when assuming a constant off-diagonal correlation structure. Equal risk weighting is
positioned somewhere in between of equal weighting and minimum variance allocation. The
idea of equal risk weighting goes backs to risk budgeting and is successfully used by, e.g.,
Managed Futures, which give equal risk budgets to the trading strategies and commodity
investments under consideration.

In the present paper, we propose a portfolio optimization approach based on the idea of equal
risk weighting. The approach, however, takes interaction effects (in the linear context:
correlations) into account and can also be used in the presence of additional constraints.

1
Thomas Neukirch is Senior Quantitative Analyst at HQ Trust GmbH, Bad Homburg, Germany, email:
neukirch@hqtrust.de.

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Electronic copy available at: http://ssrn.com/abstract=1301430

2. The approach: Optimization with respect to risk diversification

The approach is based on the risk contribution of the assets involved in an allocation problem.
Here, we will explain and develop the approach using volatility as risk measure. However, it
can also be used straight forward with other kind of risk measures, e.g., downside risk. A brief
summary using downside risk is given in the Appendix.

Assume, we have n assets indexed i = 1,...n with weights wi ≥ 0, ∑ wi = 1 , volatilities σ i and

i

correlations ρ ij , then the volatility of the overall portfolio is given by

∑w w σ σ
i, j
i j i j ρij .

Hence,

∑w w σ σ
j
i j i j ρ ij (A)

is the absolute contribution of asset i to the overall volatility and

∑w σ j j ρ ij
rwi := wiσ i ⋅
j
(B)
∑w w σ
k, j
k j k σ j ρ kj

is the relative one.

If we assume constant off-diagonal correlations, as done in [Neukirch, 2008], (B) can be

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reduced and equal risk contributions are achieved by setting w i ~ σ i .

However, if we do not assume all off-diagonal correlations to be equal or if constraints are in

place, we have to find a suitable way to measure the homogeneity of risk contributions.

A suitable measure is the entropy

− ∑ wi log(wi ) (C)
i

which is a well known measure for homogeneity (or diversity), see [Shannon, 1948] for
details. In the context of portfolio theory, [Bera and Park, 2008] were – to my knowledge –
the first ones using it. They applied it to allocation weights to calculate the most
homogeneous allocation given side conditions.

To apply this measure to risk contributions, we have to ensure, that the corresponding risk
contributions are positive, since log is defined for positive numbers only. We can achieve
that with the additional condition, that all correlations are non-negative:

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Electronic copy available at: http://ssrn.com/abstract=1301430

 ρ ij ≥ 0 ⇒ ∑ wi w j σ iσ j ρ ij ≥ wi2σ i2 > 0,
j

if wi > 0.

One typical example could be a portfolio of stocks, which behave sufficiently similar to
guarantee ρ ij ≥ 0 .

Under the condition, that all correlations ρ ij ≥ 0 , the allocation with the optimal risk
diversification can be defined to be the vector ( w1 ,..., wn ) of weights satisfying

max[ − ∑ rwi log(rwi ) ] (D)

i

with rwi defined as in (B).

But, what happens, when negative risk contributions occur? Typical example for this are
bonds in a traditional portfolio, which usually are negatively correlated to stocks or Managed
Futures in a hedge fund style portfolio. In this case, we cannot pursue approach (D).

Hence, it is reasonable to use other measures of homogeneity, which can also deal with
negative risk contributions. We propose to minimize the Euclidean distance of the risk
weights from their mean:

The allocation with the optimal risk diversification can be defined to be the vector
( w1 ,..., wn ) of weights satisfying

2
1
rw1 −
n
∑ rwi
min M M (E)
1
rwn −
n
∑ rwi

This is an intuitive measure guaranteeing that the risk weights are not too widespread. It
works in practice and yields for well posed problems without additional constraints the same
results as the entropy.

The above definitions hold also when side constraints exist. In these cases, they yield
portfolios with the most homogeneous risk diversification, given the constraints. However,
the optimization is only meaningful, if the constraints are not contrary to the optimization
goal.

The resulting portfolios are, of course, always functions of the risk and homogeneity
measures used, as illustrated in the examples in Section 3.

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3. How it works

The following example have the purpose to illustrate the power of the risk diversification
approach in a asset allocation environment comprising traditional as well as alternative asset
classes.

Given are the following asset classes together with long-term volatility assumptions from a
EUR-investor’s perspective:

Asset Classes Volatilities

Equities World 16.4%
Bonds Investmentgrade Europe 3.9%
REITS World 15.1%
Private Equity Europe 22.7%
Commodities Energy 30.1%
Commodities Non-Energy 12.8%

In this setting, we now compute the following portfolios:2

1. The portfolio which equally distributes the volatility contributions as defined in (B)

2. The minimum variance portfolio

3. The portfolio with the most homogeneous distribution of volatility contributions as

defined in (B) given an overall volatility of max. 3.25% (near the minimal volatility).
This portfolio is computed with the Euclidean distance as homogeneity measure, so it
is optimized with respect to (E). We cannot use (D), since during the optimization
process negative numbers occur.

4. To circumvent the problem with negative contributions, we computed a portfolio

analogous to 3 using volatility contributions without taking correlations into account.
Here, again with Euclidean distance as homogeneity measure.

5. This portfolio is computed analogously to 4, but with Entropy as homogeneity

measure.

The results are as follows:

2
The computations are based on the above shown volatilities and a correlation matrix, which is available upon
request. The computations were carried out using Matlab. Please note that the optimizations are non-trivial and
that convergence to the global minimum may need rescaling or use of alternative optimizations, e.g., using
genetic algorithms.

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 Homogeneity of STD Homogeneity of STD Homogeneity of STD
Homogeneity of STD
Optimization goal weights
Minimum STD weights, given STD ≤ weights, given STD ≤ weights, given STD ≤
3.25% 3.25% 3.25%

STD contributions, STD contributions,

Risk contribution measure used STD contributions STD contributions
without correlations without correlations

Homogeneity measure used Euclidean distance Euclidean distance Euclidean distance Entropy
Equities World 7.5% 4.1% 7.5% 10.1% 3.7%
Bonds Investmentgrade Europe 64.2% 81.3% 68.2% 67.5% 73.7%
REITS World 6.7% 0.0% 4.3% 0.0% 3.0%
Private Equity Europe 5.5% 4.4% 5.0% 4.5% 2.7%
Commodities Energy 6.8% 3.0% 6.0% 6.0% 2.5%
Commodities Non-Energy 9.4% 7.2% 9.0% 12.0% 14.3%
Return p.a. 5.5% 4.5% 5.2% 5.1% 4.7%
Volatility p.a. 3.5% 2.9% 3.3% 3.3% 3.1%
Skewness -0.18 0.07 -0.08 -0.12 0.16
Kurtosis 2.88 2.07 2.62 2.69 2.83
Maximum Drawdown -4.7% -1.2% -3.9% -4.2% -1.8%
Sharpe Ratio* 0.29 0.03 0.24 0.21 0.09
Sortino Ratio* 2.59 2.70 2.75 2.68 2.65
Calmar Ratio* 0.22 0.07 0.20 0.16 0.15
*Ratios with RFR =4.45%

Table 1

We see that the risk diversification approach without additional constraints produces a
portfolio similar to the minimum variance portfolio, but much better diversified. The risk
contributions as defined in (B) in both portfolios are shown in Table 2.

Homogeneity of STD
Optimization goal weights
Minimum STD

Risk contribution measure used STD contributions

Homogeneity measure used Euclidean distance
Allocation
Equities World 7.5% 4.1%
Bonds Investmentgrade Europe 64.2% 81.3%
REITS World 6.7% 0.0%
Private Equity Europe 5.5% 4.4%
Commodities Energy 6.8% 3.0%
Commodities Non-Energy 9.4% 7.2%
Resulting STD contribution
Equities World 16.67% 2.97%
Bonds Investmentgrade Europe 16.67% 84.2%
REITS World 16.67% 0.0%
Private Equity Europe 16.67% 4.8%
Commodities Energy 16.67% 1.0%
Commodities Non-Energy 16.67% 7.0%

Table 2

By construction, the risk contributions in the first portfolio are all equal. In the minimum
variance portfolio, we see a high risk concentration in bonds, which are more than 80% of the
portfolio.

The combination of both approaches leads to a portfolio (portfolio 3 in Table 1) with a

sufficient small volatility which at the same time is better diversified than the minimum
variance portfolio.

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The example also illustrates that different homogeneity measures may lead to different
results: Portfolios 4 (computed with Euclidean distance) and 5 (computed with Entropy) in
Table 1 differ in their allocations, in particular in Equities and REITS. The resulting risk
contributions for these portfolios are shown in Table 3.

Homogeneity of STD Homogeneity of STD

Optimization goal weights, given STD ≤ weights, given STD ≤
4% 4%

STD contributions, STD contributions,

Risk contribution measure used without correlations without correlations

Homogeneity measure used Euclidean distance Entropy

Allocation
Equities World 10.1% 3.7%
Bonds Investmentgrade Europe 67.5% 73.7%
REITS World 0.0% 3.0%
Private Equity Europe 4.5% 2.7%
Commodities Energy 6.0% 2.5%
Commodities Non-Energy 12.0% 14.3%
Resulting STD contribution
Equities World 21.8% 3.7%
Bonds Investmentgrade Europe 24.7% 54.5%
REITS World 0.0% 6.1%
Private Equity Europe 13.2% 3.4%
Commodities Energy 16.0% 0.9%
Commodities Non-Energy 24.3% 31.5%

Table 3

4. Conclusion

We proposed a new kind of portfolio optimization focusing on risk diversification. Positioned

somewhere in between equal weighting and risk minimization, it draws from the ideas of
naïve diversification, rebalancing, risk reduction and error minimization.

The implementations we proposed are easy to understand and intuitive and can also be
applied if additional constraints are in place. The use of the Euclidean distance as
homogeneity measure offers the possibility to optimize also when negative risk contributions
occur.

The approach is promising, since it leads to better diversified portfolios without the need of
manual adjustments.

References

Bera, A.K. and Park, S.Y. 2008. Optimal Portfolio Diversification using Maximum Entropy.
Econometric Reviews, vol. 27, issue 4-6, p.484-512

Grootveld, H. and Hallerbach, W. 1999. Variance vs downside risk: Is there really that much
difference? European Journal of Operational Research 114, p. 304-319

Hogan, W.W. and Warren, J.M. 1972. Computation of the efficient boundary in the E-S portfolio
selection model. Journal of Financial and Quantitative Analysis, p.1881-1896.

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Markowitz, H. 1952. Portfolio Selection. Journal of Finance, vol. 7, p.77-91

Neukirch, Th. 2008. Alternative Indexing with the MSCI World Index. SSRN Working paper

Shannon, C.E. 1948. The mathematical theory of communication. Bell System Technical Journal, vol.
27, p.379-423

Treynor, J. 2005. Why Market-Valuation-Indifferent Indexing Works. Financial Analysts Journal, vol.
61, no. 5: p.65-69.

Appendix

Implementation when using shortfall volatility as measure of risk

The shortfall variance is defined as

E [ (max (0, r0 − rp )) ],
2
(F)
with E denoting the expectation operator, r0 being the minimum acceptable return and rp
being the portfolio return.

With rp = ∑i ri wi and using ∑i wi = 1 , we can restate (F) as follows:

E [ (max (0, r0 − rp )) ]
2

= E [ max (0, r0 − rp )⋅ (r0 − rp ) ]

(
= E [ max (0, r0 − rp )⋅ r0 − ∑i ri wi )] (G)

= ∑i wi ⋅ E [ max (0, r0 − rp )⋅ (r0 − ri )]

The summands can be interpreted as the absolute shortfall variance contributions of the
portfolio constituents.3

The optimal portfolios with respect to shortfall volatility homogeneity can then simply be
computed using the summands in (G) as absolute contributions when optimizing (E) or (D).

3
A further decomposition as in the variance calculus is not possible, since (G) is not a quadratic form. Hence we
always need the entire joint distribution to calculate (G); for a discussion see [Grootfeld and Hallerbach, 1999].

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