Risk Parity Portfolios with Skewness Risk: An Application to Factor Investing and Alternative Risk Premia

TL;DR

This paper introduces a model incorporating skewness risk into risk parity portfolios, using Gaussian mixture distributions to improve asset allocation, especially for assets with jump risks like short volatility strategies.

Contribution

It develops an analytical framework for skewness-aware risk parity portfolios, providing formulas for risk contributions and conditions for portfolio existence and uniqueness.

Findings

Skewness-based risk parity portfolios outperform volatility-based ones for assets with jump risks.

The model effectively manages skewness risk in equity factor portfolios.

Application to alternative risk premia demonstrates improved allocation strategies.

Abstract

This article develops a model that takes into account skewness risk in risk parity portfolios. In this framework, asset returns are viewed as stochastic processes with jumps or random variables generated by a Gaussian mixture distribution. This dual representation allows us to show that skewness and jump risks are equivalent. As the mixture representation is simple, we obtain analytical formulas for computing asset risk contributions of a given portfolio. Therefore, we define risk budgeting portfolios and derive existence and uniqueness conditions. We then apply our model to the equity/bond/volatility asset mix policy. When assets exhibit jump risks like the short volatility strategy, we show that skewness-based risk parity portfolios produce better allocation than volatility-based risk parity portfolios. Finally, we illustrate how this model is suitable to manage the skewness risk of long-only equity factor portfolios and to allocate between alternative risk premia.