Risk Budgeting Portfolios Under a Modern Optimization and Machine Learning Lens

Abstract

The mean-variance optimization framework has been the traditional approach to decide portfolio allocations based on return-risk trade-offs. However, it faces practical drawbacks, including sensitivity to estimated input parameters and concentration of portfolio risk. Risk budgeting portfolio optimization is a popular risk-based asset allocation technique where risk budgets are assigned to each assets' risk contribution, and equalizing all risk budgets in the portfolio is known as risk parity strategy. Unlike mean-variance, the risk parity strategy provides a balanced risk concentration in the portfolio and does not require expected asset return estimates as input. However, its performance can depend on the selected asset universe. Furthermore, its mathematical formulation imposes some computational challenges due to the non-convex structure. In this thesis, the risk budgeting problem is studied with modern optimization and machine learning approaches to enhance the portfolio model and address the aforementioned challenges. The second chapter introduces regime-switching risk parity portfolios with two primary components: regime modeling and prediction with supervised learning methods and identifying a regime-based strategy to improve the performance of a nominal risk parity portfolio. In the third chapter, we formulate a multi-period risk parity portfolio optimization problem in a transaction cost environment with a model predictive control approach. We provide a successive convex program algorithm that provides faster and more robust solutions. Lastly, we present an end-to-end portfolio allocation method by embedding the risk budget optimization problem as an implicit layer in a neural network. This approach combines prediction and optimization tasks in a single decision-making pipeline and constructs dynamic risk budgeting portfolios. Furthermore, we introduce a novel asset selection property with stochastic gates that protects the risk budgeting portfolio against the unprofitable assets.