What’s the latest research on portfolio construction and risk management? In the the introduction to the July 2014 version of his (book-length) paper entitled “Many Risks, One (Optimal) Portfolio”, Cristian Homescu states: “The main focus of this paper is to analyze how to obtain a portfolio which provides above average returns while remaining robust to most risk exposures. We place emphasis on risk management for both stages of asset allocation: a) portfolio construction and b) monitoring, given our belief that obtaining above average portfolio performance strongly depends on having an effective risk management process.” Based on a comprehensive review of recent research on portfolio construction and risk management, he reports on:
- Empirical behavior of market returns.
- Principal ways of constructing a diversified portfolio (Modern Portfolio Theory, Black-Litterman model, factor-based strategies and risk-based strategies), including criticisms, defenses and practical issues.
- Recent enhancements to portfolio construction strategies, including incorporation of constraints, regularization (suppression of forecast instabilities), personal views, empirical return behaviors and forward views from options.
- Details on strategies that exhibit especially good performance in terms of return, diversification and risk (risk parity, risk factors, factor investing, smart beta, dynamic).
- A broad collection portfolio return, risk and diversification metrics, including those most popular with practitioners.
- Types of portfolio risk exposures and approaches for handling these exposures, highlighting tail risk management.
- Practical aspects of portfolio management, including robust estimation of covariances, correlations and model parameters (numerical optimization methods, Monte Carlo simulation, stress testing and available software programs).
“In a nutshell, the study has analyzed all ingredients that are required…to deliver portfolios with above average performances and resilient to most risks, and has concentrated on the strategies which have emerged as frontrunners in the last few years, both in the literature and in the market.”
Cautions regarding the summary include:
- Many methods covered are likely beyond the reach of typical investors (or costly if delegated).
- This paper mostly summarizes other research without extension or meta-conclusions.
- The summarized body of research may include studies that do not rigorously account for data snooping bias (see “Chapter 3: Avoiding or Mitigating Snooping Bias”) and implementation frictions (see “Chapter 4: Accounting for Implementation Frictions”).
