Equally Weighted (EQW) Portfolio; Diversified Risk Parity (DRP)

Equally Weighted (EQW) Portfolio; Diversified Risk Parity (DRP) Equally Weighted (EQW) Portfolio; Diversified Risk Parity (DRP) Portfolio; Maximum Diversification Ratio (MDR) Portfolio ;Global Minimum Variance (GMV) Portfolio â€" Research Paper Example > Finance and Accounting This paper will explain and analyse the following four strategies giving theirmerits and demerits in use. These strategies are risk diversification strategies that can be used to analyse a range of portfolios. 2.1 Equally Weighted (EQW) Portfolio It is a type of diversification where each stock in the portfolio is given equal importance or weight. It allows all of the stocks in the portfolio to be considered on an even ground and can be viewed as a portfolio that achieves potential benefits from international investments without using historical data or information of the performance of the investment (Perold, 2007, 33). Equal waiting spreads the portfolio’s risk in such a way that the investor can gain from the developed portfolio on rebalancing. This feature has high turnover problems and issues with liquidity (DeMiguel, Garlappi and Uppal, 2009). To get the weight of the scheme in comparison to the optimal portfolio constituted by the Maximum Sharpe Ratio (MSR) portfolio we use the following formulae. Wew= 1 Where Wew is weigh of the scheme N is the number of stocks In addition, the following optimality conditions assumed µi = µ si = s ?ij = ? µi is the expected return on stock i, si is the volatility for stock i, ?ij is the correlation between stocks i and j. Advantages of EWQ i. They are attractive because they avoid the concentration and trend following of cap-weighted indices. ii. They lead to higher Sharpe ratios compared to their cap-weighted portfolio methods. iii. It is a simple way of de-concentrating a portfolio and allows us to benefit from systematic rebalancing back to fixed weights. Disadvantages of EWQ i. It does not take into account historical data of the investments this may lead to lower returns. ii. By giving equal importance to each investment, better performing investment may be overlooked hence missing out on higher returns. 2.2 Diversified Risk Parity (DRP) Portfolio Risk parity is an approach to investment in a portfolio, which focuses on allocation or risk rather than allocation of capital. To achieve a higher Sharpe ratio in a risk parity portfolio, the risk of the portfolio should be adjusted to the same level (Petkova and Zhang, 2005, 192). According to (Maillard, Roncalli and Teiletche, 2010, 62) the risk-parity portfolios would be optimal Maximum Sharpe Ratio (MSR) portfolios if the Sharpe ratios and correlation are identical for all investments. The portfolio weights are proportional to the inverse of the volatility (Maillard, Roncalli and Teiletche, 2010, 65): WDRP= Where 1 is a vector of ones s is the vector of volatilities Advantages of DRP i. It considers the risk of the investment hence it works to minimize the risk of the overall portfolio. Disadvantages of DRP i. It has very restrictive assumptions. ii. There is no analytical solution to the DRP program. 2.3 Maximum Diversified Risk (MRD) Portfolio Maximum Diversified Risk Portfolio is a strategy, which can be used to calculate the ratio for the most diversified portfolio. This is done by use of a Diversification Ratio, which shows the relationship between the individual volatilities and the portfolio volatilities. According to (Choueifaty and Coignard, 2008, 45), the diversification ratio is computed as follows: DI= Where: wi is the portfolio weight si the volatility of stock i sij the covariance between stocks i and j This diversification index has been used to formulate the Maximum Diversified Ratio formula that can help get the optimum portfolio. It is as shown below: WMDR= Where: 1 is a vector of ones s is the vector of volatilities S is the covariance matrix Using this formula, one can be able to obtain the optimum portfolio where the risks are diversified fully to get the maximum returns from the portfolio. The correlations of each individual instrument to the MDR portfolio are minimized and made equal. This strategy of hedging has various advantages and disadvantages as follows. Advantage of MDR Portfolio Since it uses a measure of portfolio diversification, the ratio helps investors to obtain improved efficiency as compared to other strategies. Disadvantage of MDR Portfolio i. The combination of the correlation of individual instruments exceeds the overall portfolio correlation, hence may be a source of losses. ii. (Choueifaty and Coignard, 2008, 47), acknowledge that the solution of the MDR formula may not be unique, particularly with ill-conditioned covariance matrices. 2.4 Global Minimum Variance (GMV) Portfolio The GMV achieves the least volatility as it pertains correlations as well as volatilities. The Global minimum variance can be calculated as follows: WGMV= Where: 1 is a vector of ones S is the covariance matrix This means that the correlations for individual instruments should be in existence for the investor to obtain the minimum variance that optimises the portfolio. However, the main purpose of GMV is to estimate the lowest risk for an investment opportunity. This strategy has been criticised for: i. Having pronounced concentration in low volatility stocks at the expense of exploiting correlation properties (Amenc and Martellini, 2002, 11). ii. Despite the low volatility stocks being attractive or unattractive, using a GMV strategy leads to poorly diversified portfolios and does not use correlations of individual instruments in full. iii. It is also clear that when using this strategy, it is hard to obtain a high diversification of risk in a portfolio as compared to using other strategies such as the Maximum Diversified Ratio (Bali and Cakici, 2008, 37). However, the GMV is a good strategy for analysing portfolios despite the several constraints. In conclusion, the four strategies, tha t is Equally Weighted (EQW) Portfolio, Diversified Risk Parity (DRP) Portfolio, Maximum Diversification Ratio (MDR) Portfolio and Global Minimum Variance (GMV) Portfolio are strategies used in hedging and analysing the optimality of different portfolios. This varies due to the instruments available for the investor and the risk attitude of the investor. References Amenc, N. and L. Martellini. 2002. “Portfolio optimization and hedge fund style allocation decisions”, Journal of Alternative Investments, 5(2) 7-20 Bali, T., and N. Cakici. 2008. Idiosyncratic volatility and the cross-section of expected returns. Journal of Financial and Quantitative Analysis 43:29-58. Choueifaty, Y. and Y. Coignard. 2008. Toward Maximum Diversification. Journal of Portfolio Management 35(1): 40-51. Clarke, R., H. de Silva and S. Thorley. 2013. Risk Parity, Maximum Diversification, and Minimum Variance: An Analytic Perspective. Journal of Portfolio Management DeMiguel, Victor, Lorenzo Garlappi, and Raman Uppal, 2009, “Optimal versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy? ” Review of Financial Studies 22(5), 1915â€"1953 Maillard, S., T. Roncalli and J. Teiletche. 2010. The Properties of Equally Weighted Risk Contribution Portfolios. Journal of Portfolio Management 36(4): 60-70. Perold, A. 2007. Fundamentally Flawed Indexing. Financial Analysts Journal 63(6): 31-37. Petkova, R. and L. Zhang. 2005. Is Value Riskier than Growth? Journal of Financial Economics 78: 187-202.