Asset Allocation Strategy with Non-Hierarchical Clustering Risk Parity Portfolio

Abstract

Since the great financial crisis of 2008, many studies have pointed out that even in the portfolio where the asset allocation is sufficiently diversified, it is still possible that risk allocation is well concentrated to a few assets. One approach to this problem is risk parity strategies which equalize the risk contribution of each asset. However, even if we equalize the risk contribution, risk sources are not necessarily diversified. In this paper, we propose non-hierarchical clustering-risk parity strategy which will equalize risk contribution from and within each cluster. In addition, in order to ensure robustness of clustering, we also propose x-means++ algorithm which combines k-means++ with x-means. Assuming assets with similar movement have common risk sources, our approach will construct a portfolio which equalizes risk sources. Empir-ical analysis using actual price data of various asset classes shows that our proposed method will outperform risk-parity strategies or hierarchical clustering risk parity strategies.