Diversified reward-risk parity in portfolio construction

TL;DR

This paper proposes a diversified reward-risk parity approach for portfolio construction that improves performance and risk profiles compared to traditional methods, with empirical validation across various asset classes.

Contribution

It introduces a novel diversified reward-risk parity method with generic allocation rules and demonstrates its superior performance over equal-weighted risk portfolios.

Findings

Higher average returns, Sharpe, and Calmar ratios.

Reduced downside risks like VaR and maximum drawdown.

Lower transaction costs due to decreased turnover.

Abstract

We introduce diversified risk parity embedded with various reward-risk measures and more generic allocation rules for portfolio construction. We empirically test the proposed reward-risk parity strategies and compare their performance with an equally-weighted risk portfolio in various asset universes. The reward-risk parity strategies we tested exhibit consistent outperformance evidenced by higher average returns, Sharpe ratios, and Calmar ratios. The alternative allocations also reflect less downside risks in Value-at-Risk, conditional Value-at-Risk, and maximum drawdown. In addition to the enhanced performance and reward-risk profile, transaction costs can be reduced by lowering turnover rates. The diversified reward-risk parity allocations gain superior performance in the Carhart four-factor analysis.