Cluster Risk Parity– A Visual Representation
The following graphic is borrowed from a static risk parity approach via Salient Capital Advisors: http://www.theriskparityindex.com/static/pdfs/Salient-Risk-Parity-Index-White-Paper.pdf. The visual is useful for readers to understand the nuances and relative merits of a Cluster Risk Parity (CRP) approach. In their approach the individual assets and clusters are defined in advance, and thus there is no dynamic clustering method used. However, the concept that they use is similar: balance risk contributions both within and across “clusters” of assets. In this case it is important to clarify that the size/area of each slice of the pie chart is a function of risk contributions NOT percentage capital allocations.
As you can clearly see from this specific chart, it is very similar in spirit to the “All-Weather” Portfolio or even the simpler Permanent Portfolio . The main difference is that the latter portfolio schemes represent “strategic asset allocation” alternatives, while Cluster Risk Parity (and also the Salient Index) is a dynamic asset allocation framework. GestaltU does a good job describing why it is important to prefer dynamic approaches in a recent post: http://gestaltu.blogspot.com/2013/01/the-full-montier-absolute-vs-relative.html. In reference to CRP the advantage is creating a framework that does not require having to pre-specify the assets and weights in advance on a static basis. Instead, it permits the ability for the portfolio to adapt to changes in the variance/covariance matrix of asset returns — which have proven especially useful in a dynamic framework to normalize risk exposure. This framework is so generic that it can be adapted to any type of risk factor or regime framework with relative ease.