Alpha-factor integrated risk parity portfolio strategy in global equity fund of funds

ABSTRACT

This study proposes a principal alpha-style factor integrated risk parity strategy that can diversify style risk factors and the stock selection risk of external managers in Fund-of-Funds (FoFs) portfolios. First, we separated the style risk factors and stock-specific sources held by each individual fund. Stock-specific sources, referred to as principal alpha portfolios, are extracted through principal component analysis, where the sources are utilized for risk parity in the alpha division. As the parity portfolio was integrated into both the alpha and style factor divisions, we used a Basin-Hopping two-phase optimization technique, which can mitigate the local optimal trap by exploring the surroundings of the sequential quadratic programming solution secondarily. Through this, a more stable integrated risk parity portfolio can be realized. Finally, the suggested integrated risk parity portfolios were simulated with a global fund dataset. The simulation results from 2006 through June 2022 show a more stable risk-return profile than an independently constructed strategy using style risk factors or principal alpha sources, especially in high volatility and down-market periods, such as a global financial crisis or unexpected events like COVID-19. This study can be applied to various areas covering other FoFs and asset allocation strategies by integrating alpha and factor divisions. © 2023 Elsevier Inc.