Build a risk-parity strategy with the PORT optimizer

Bloomberg Market Specialists Constantin Cosereanu and Douglas Edler contributed to this article. The original version appeared first on the Bloomberg Terminal.

What should your post-pandemic asset allocation look like? Coming off a year with all-time-high volatility readings and ­amazingly good performance, some investors may be considering an equal-risk style of asset allocation known as risk parity.

Famously associated with the All Weather portfolio at Ray Dalio’s Bridgewater Associates, the strategy allocates the same amount of risk to different asset classes.

While there are many ways to build a strategy based around this concept, here’s a simple way to do it: Use the optimizer in the Portfolio & Risk Analytics (PORT) function. Here’s how you can explore such a strategy.

Let’s use seven indexes to represent a variety of bonds, stocks, real estate, and commodities:

1. Bloomberg Barclays US Treasury Index {LUATTRUU Index}
2. Bloomberg Barclays US Aggregate Bond Index {LBUSTRUU Index}
3. Bloomberg Barclays US Corporate High Yield Index {LF98TRUU Index}
4. Bloomberg US Large Cap Price Return Index {B500 Index}
5. Bloomberg US 2000 Price Return Index {B2000 Index}
6. Bloomberg US REITs Index {BBREIT Index}
7. Bloomberg Commodity Index {BCOM Index}

You can find data and tickers for these and other benchmarks by running IN <GO>. The question is: What asset allocations do we need to achieve a portfolio equally weighted by risk contribution per asset class?

Create two portfolios

Let’s start by creating a $1 million cash portfolio in the Portfolio Administration function. Type “portfolio administration” in the command line of a terminal screen and click on the PRTU – Portfolio Administration match. The shortcut is PRTU <GO>.

Click the Create button on the red toolbar. Give the portfolio a name such as “Main Cash Portfolio.” Use the drop-downs to select Equity as the Asset Class, USD as the Portfolio Currency, and Shares/Par Amount as the Position Type. Click the Create button.

In the amber field under Cash, enter “USD” and click on USD Crncy – United States Dollar Spot. In the Position field, enter “1K”—PRTU scales cash by a factor of 1,000—and press GO. Hit Save.

Next, repeat the steps to create another portfolio holding the seven indexes. Run PRTU <GO> again, click Create, give the portfolio a name such as “Asset Mix Strategy,” and click on the Create button. Add the indexes. Type “LUATTRUU” in the field below Cash and click on the match. Position is irrelevant because we’ll use the PORT ­optimizer to generate the appropriate asset allocation, so you can enter “1,” for example, in the Position field and press GO. Repeat to enter the other indexes.

To create a portfolio containing the assets you want to use for a risk-parity strategy, run PRTU <GO> and click on the Create button. Because we’ll be using the PORT optimizer to set allocations, position is irrelevant. Enter “1” in the Position field.

To create a portfolio containing the assets you want to use for a risk-parity strategy, run PRTU <GO> and click on the Create button. Because we’ll be using the PORT optimizer to set allocations, position is irrelevant. Enter “1” in the Position field.

When you’re done, hit Save.

Build an optimization

Run PORT <GO> to open the Portfolio & Risk Analytics function. Use the drop-down in the upper left corner to select the cash portfolio. Next, click on Trade Simulation and select Launch Optimizer.

The optimizer enables you to specify goals, the universe you want to trade from, constraints, and security-level properties.

Ultimately what we’re looking to do here is end up with equal risk contributions from each of the asset classes. In the Goals section, first remove any goal that’s already loaded by clicking on the red delete icon. Then click the Add button. Type “contribution to total risk” in the Search field and press GO. Click on it in the Select Field portion of the window, then hit the Select button.

In the Trade Universes section, let’s set the portfolio with the indexes as our trade list. Click on the pencil icon. In the window that appears, click on User Portfolio, navigate to the Asset Mix Strategy portfolio, and click on it to select it. Make sure Trade List is selected as the Trade Rule and click on Select.

Finally, in the Security Properties section of the screen, we’re going to specify that each asset class has an equivalent risk contribution. In the amber field that says , enter “LUATTRUU” and click on the matching index. Then enter “1” in the RskCtr field to the right and press GO. Repeat for the other indexes in your strategy.

To set up an optimization, run PORT <GO> and load the cash portfolio. Then click the Trade Simulation button on the red toolbar and select Launch Optimizer. Set the goal here to Minimize Contribution to Total Risk. In the Securities Properties section, we’re assigning an equal value to risk contribution for each of the assets.

To set up an optimization, run PORT <GO> and load the cash portfolio. Then click the Trade Simulation button on the red toolbar and select Launch Optimizer. Set the goal here to Minimize Contribution to Total Risk. In the Securities Properties section, we’re assigning an equal value to risk contribution for each of the assets.

That’s it; you don’t need to add any other portfolio-level constraints. Click the Tasks button on the red toolbar and select Save Task As … to save the task so you can rerun it. Give the Task a name and hit Save.

To run the optimization, click on the Run button. The Proposed Trades section shows purchases from the trade list.

Once you set up the task, click on the Run button to start the optimization. Here the optimization has proposed a 37% weight in the Treasuries index.

Once you set up the task, click on the Run button to start the optimization. Here the optimization has proposed a 37% weight in the Treasuries index.

Run in early January, the optimizer proposed buying the US Treasury index to a weight of 37% in the portfolio. The aggregate bond benchmark would get a 31.5% weight, high yield 18%, large cap 5.6%, REITs and small caps 3.5%.

Click on the Analyze in PORT button to see the simulated portfolio in PORT. Click on the Tracking Error/Volatility tab and then on the Main View subtab.

Click on the Analyze in PORT button. Then click on the Tracking Error/Volatility tab and the Main View subtab.

Click on the Analyze in PORT button. Then click on the Tracking Error/Volatility tab and the Main View subtab.

The Contribution % column shows that the optimization has resulted in an almost identical contribution to total risk for each of the seven indexes.

Note that the above analysis is based on Bloomberg’s ­Multi-Asset Class (MAC) Risk model. For more information on it, go to HELP PORT <GO> and click on White Papers.

To further explore asset allocation, you can use some ­ready-made asset-allocation-related Excel spreadsheets. The Asset Allocation Optimizer enables you to perform mean-variance optimization. Run XLTP XAAO <GO> and click on the Open button to download a copy. Go to XLTP XAAC <GO> for the Asset Allocation Calculator, which lets you create a so-called quilt chart to track the historical performance of asset classes.

To download a sample spreadsheet that lets you analyze the historical performance of different asset classes, run XLTP XAAC <GO> and click on the Open button.

To download a sample spreadsheet that lets you analyze the historical performance of different asset classes, run XLTP XAAC <GO>; and click on the Open button.

Finally, run XLTP XAAA <GO> for the Asset Allocation Analyzer, which allows you to determine over- or undervaluation of multiple asset classes.

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