The Journal of Portfolio Management
Portfolio management is moving toward a more flexible approach capable of capturing dynamics in risk and return expectations across an array of asset classes. The change is being driven, in part, by the observation that risk premiums vary as investors’ cycle between risk aversion and risk adoration and that the decision to invest — whether to take risk and how much — is the most important investment decision.
Certainly, managers should take risks, but only if the returns appear to represent fair compensation. This all suggests that the traditional strategic approach of fixed-asset allocation is outmoded. The challenge of portfolio choice is much more than merely selecting for inclusion uncorrelated asset classes that constitute significant economic exposure and then specifying a fixed proportion of each.
We propose a model of portfolio selection with heavy tails and dynamic return correlations. The powerful intuition behind our approach is that proper portfolio construction is an ongoing, dynamic process that integrates time-varying risks of the various asset classes within the investor’s portfolio.
We develop a dynamic asset allocation framework that determines an investor’s optimal portfolio in accordance with changing global market environments and market conditions. Specifically, we consider how global return, variance, and covariance characteristics vary across time and states of global markets for a diversified portfolio of asset classes. We then use this dynamic information to consider the asset allocation implications in a practical setting.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.
This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.