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 of January 1993 to August 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.