Market integration : a risk budgeting guide for pure alpha investors

A long-short beta neutral portfolio strategy is constructed based on earnings yields

forecasts and a shrunk covariance matrix. Positions are modified with an innovative technique

of time-varying risk budgeting based on an integration measure. We consider a set of 14

developed equity markets indexes for the period 01:1993 to 08:2006 in local currencies. Our

resulting market neutral strategy has an Information ratio of 1,2 compared to 0,8 for a strategy

without risk budgeting. We rely on a Principal Components Analysis to extract the factors with

which we build an integration measure and we relate these factors to the framework of an asset

pricing model. We also show the results taking into account transaction costs and the use of a

single currency.