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SSRN-id1949003

SSRN-id1949003

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Published by: stepchoiny on Jul 03, 2012
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Electronic copy available at: http://ssrn.com/abstract=1949003
Electronic copy available at: http://ssrn.com/abstract=1949003
Electronic copy available at: http://ssrn.com/abstract=1949003
1
Demystifying Equity Risk-Based Strategies:
 A Simple Alpha plus Beta Description.
Raul Leote de Carvalho
is head of Quantitative Strategies and Research in the Financial Engineering team at BNP ParibasInvestment Partners in Paris, France.raul.leotedecarvalho@bnpparibas.com,Tel. +33 (0)1 58 97 21 83
Xiao Lu
is a quantitative analyst in the Financial Engineering team at BNP Paribas Investment Partners in Paris,France.xiao.lu@bnpparibas.com, Tel. +33 (0)1 58 97 75 64
Pierre Moulin
is head of Financial Engineering at BNP Paribas Investment Partners in Paris, France.pierre.moulin@bnpparibas.com, Tel. +33 (0)1 58 97 20 52
13 September 2011
BNP Paribas Asset Management, 14 rue Bergère 75009 Paris, France
 
Electronic copy available at: http://ssrn.com/abstract=1949003
Electronic copy available at: http://ssrn.com/abstract=1949003
Electronic copy available at: http://ssrn.com/abstract=1949003
2
Abstract
We considered five risk-based strategies: equally-weighted, equal-risk budget, equal-risk contribution,minimum variance and maximum diversification. All five can be well described by exposure to themarket-cap index and to four simple factors: low-beta, small-cap, low-residual volatility and value. This is,in our view, a major contribution to the understanding of such strategies and provides a simple framework to compare them. All except equally-weighted are defensive with lower volatility than the market-capindex. Equally-weighted is exposed to small-cap stocks. Equal-risk budget and equal-risk contribution areexposed to small-cap and to low-beta stocks. These three have a high correlation of excess returns andtheir portfolio largely overlap. They invest in all stocks available and have both a low turnover and lowtracking error relative to market-cap index. Minimum variance and maximum diversification areessentially exposed to low-beta stocks. They are the most defensive, invest in much the same stocks andhave high tracking error and turnover.
 
Electronic copy available at: http://ssrn.com/abstract=1949003
Electronic copy available at: http://ssrn.com/abstract=1949003
3
Equity risk-based strategies are systematic quantitative approaches to stock allocation which relyonly on risk views to manage risk and increase diversification. These strategies do not requireany explicit stock return forecasts. The portfolios are periodically rebalanced to take into accountdrift and changes in risk views.The simplest of these strategies is based on the equally-weighed (EW) portfolio which simplyfollows the principle of not putting all your eggs in one basket. The portfolio invests the sameamount in each stock and makes sense if we believe that neither stock returns nor risk can beforecast.The equal-risk budget (ERB) strategy invests in portfolios with the same risk budget for each
stock (which is defined as the product of the stock‟s weight to its v
olatility). Risk is equallydistributed among the stocks and hence riskier stocks get smaller weights. This can be seen as anextension of EW if we trust volatility forecasts.If correlations are also taken into account, then we can think in terms of equal-risk contribution(ERC), where the contribution to risk from each stock is the same. Unlike the risk budget, the
contribution to risk (defined as the product of the stock‟s weight to its marginal risk 
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) also takesinto account the impact of correlations. The contribution to portfolio risk from two stocks withthe same volatility but different correlations is higher for the stock with higher correlations andhence it gets a smaller weight in ERC. The ERC strategy was discussed recently by Maillard,Roncalli and Teiletche [2010].These three strategies assume diversification can be achieved by equally allocating wealth or risk across the investment universe. The two other risk-based strategies we analyse are different.Minimum variance (MV) invests in the portfolio with the lowest ex-ante volatility. MV is theleast risky approach to investing in equities and is expected to deliver the lowest volatility overtime. It uses volatilities and correlations as inputs and should invest in stocks with the lowestvolatility and low correlations.The maximum diversification (MD) strategy, introduced by Choueifaty and Coignard [2008],invests in the portfolio that maximises a diversification ratio. This ratio is the sum of the risk 

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