One of the concepts that I have developed with Michael Kapler at Systematic Investor : http://systematicinvestor.wordpress.com/ is a method of passive portfolio allocation (omitting expected or historical returns) that captures the true spirit of diversification. It is a more elegant but also more complex than our heuristic algorithm: Minimum Correlation.
This new method is called “Cluster Risk Parity” (CRP) and combines the use of cluster algorithms with risk parity and equal risk contribution. The core of this method is ideal for indexation: isolate groups of assets (or stocks) and then efficiently allocate both within and across groups. The purpose is to avoid the need for artificial or manual grouping while simultaneously adding a layer of risk management. By clustering, it is possible to dynamically maximize the diversification benefits without having as much sensitivity to the errors in the correlation matrix.
Furthermore, this promotes the use of all of the possible assets in the universe which is a desirable way to distribute risk and minimize tracking error. By using risk parity, we can efficiently normalize risk both within and across groups: in CRP we are making nearly equivalent or exactly equal risk bets across the portfolio. The combination is perhaps the most robust method of passive portfolio allocation, and it also produces the best risk-adjusted returns without relying as much on the low-volatility factor or bond/fixed income performance.
More to follow………….