Risk Budget Management under a Factor Investment Framework: Theoretical Extension and Application in Target Volatility Strategies

Abstract

In recent years, China's stock market has transitioned between bear and bull markets. Smart Beta strategies combine the strengths of active and passive investing, effectively enhancing risk control and return generation capabilities in asset allocation. Although this strategy has achieved significant scale in foreign financial markets, fund products based on Smart Beta strategies remain relatively small in scale domestically. This study utilizes approximately five years of daily data (from 2021 to present) from representative indices of various style factors. Employing the sequential least squares algorithm, it constructs a four-factor portfolio combining low-correlation factors with strong risk-hedging capabilities and the green finance ESG factor—suitable for long-term development. This approach validates the limited scope of integrating ESG factors into asset allocation while determining the optimal weightings for this four-factor portfolio across different expected volatility ranges. The findings demonstrate that incorporating ESG factors can indeed optimize asset allocation outcomes. However, portfolio weights must be dynamically adjusted according to target volatility levels to achieve effective risk control capabilities during implementation.