Shrinkage Estimation in Risk Parity Portfolios Nabil Alkafri * Christoph Frey † September 24, 2021 Abstract We investigate the impact of shrinkage estimation techniques for the moments of asset returns on risk-parity portfolios. In contrast to mean-variance port- folios, the risk contributions of individual assets in risk-parity portfolios are fixed a priori. This additional restriction is commonly found to stabilize em- pirical portfolio weights in time. We show that the marginal risk-budget for each portfolio asset indeed serves as a natural shrinkage target and hence provide a new perspective on risk-parity portfolios. In an extensive empiri- cal application, we compare and combine the various shrinkage strategies to popular risk-based approaches from the literature. We find that while using shrinkage estimators in risk-parity portfolios enhances out-of-sample perfor- mance based on various criteria, traditional covariance shrinkage estimators dominate all other strategies in high-dimensional settings. Keywords: Estimation risk, regularization, asset allocation, portfolio optimization, variance-covariance shrinkage JEL Classifications: C13, C52, C58, C61, G11 * WHU – Otto Beisheim School of Management, Vallendar, Germany. Email: [email protected] † Erasmus University Rotterdam. Email: [email protected]
Shrinkage Estimation in Risk Parity Portfolios
Jun 19, 2023
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