Paper Champions 'Dynamic Portfolio Construction' to Manage Risk

(February 6, 2012) — A dynamic portfolio construction framework will improve portfolio performance by adjusting asset allocation in accordance with a forecast of market risk, according to a recent paper.

“Portfolio management is moving toward a more flexible approach capable of capturing dynamics in risk and return expectations across an array of asset classes,” the paper written by Peng Wang and Yizhi Ge of Georgetown University and Rodney N. Sullivan of the CFA Institute assert. “The change is being driven, in part, by the observation that risk premiums vary as investors’ cycle between risk aversion and risk adoration and that the decision to invest—whether to take risk and how much—is the most important investment decision. Certainly, managers should take risks, but only if the returns appear to represent fair compensation.”

The authors conclude that the traditional strategic approach of fixed-asset allocation is outmoded, and that therefore,  there is much-needed dynamic flexibility to the asset allocation process. When asked how dynamic portfolio construction compares with a risk parity strategy, Sullivan told aiCIO: 

“While risk parity attempts to equalize risk across assets within a portfolio, a dynamic risk approach aims to adjust risk levels across the entire portfolio in accordance with a market risk forecast. While risk parity has generally the same asset weighting across all market environments in the short-term, our model dynamically adjusts portfolio asset allocations commensurate with the market risk environments.”

The similarity between risk parity and dynamic portfolio construction, however, is that both approaches attempt to manage overall portfolio risk, the authors conclude. “We know we can manage risk, but we can’t manage return,” Sullivan said. “We can forecast risk, but we must take whatever returns are offered by markets.” Wang added: “Risk parity defines risk with volatility, while we think downside risk (tail risk) is more relevant.”

Read the paper “Risk-Based Dynamic Asset Allocation with Extreme Tails and Correlations” here. 

Related article: Trustees, CIOs Question Assumptions Behind Risk Parity, Dynamic Asset Allocation