Alternative risk premia: contagion and portfolio choice

Portfolio managers regard contagion as the death of diversification. The simultaneous jump to worst decile returns for most investments in a portfolio is hard to offset by diversification alone. Our results find substantial contagion across ARP strategies, which is difficult to predict. We derive the optimal asset allocation for an ARP portfolio under contagion risk and show that the investor’s best defence is to take less portfolio leverage. In addition, he should shy away from assets that perform poorly in contagion states.