Portfolio of Risk Premia: A New Approach to Diversification

Traditional approaches to structuring policy portfolios for strategic asset allocation have not provided the full potential of diversification. Portfolios based on a 60/40 allocation between equities and bonds remain volatile and dominated by equity risk. In this article, the authors introduce a different approach to portfolio diversification, constructing portfolios using available risk premia within the traditional asset classes or risk premia from systematic trading strategies rather than focusing on classic risk premia, such as equities and bonds. Correlations between many risk premia have historically been low, offering significant diversification potential, particularly during periods of distress. These diversification benefits are illustrated with a simple asset allocation case study. From 1995 to 2009, an equal-weighted allocation across 11 style and strategy premia realized similar returns to a traditional 60/40 allocation, but with 70% less volatility.