Equal Risk Allocation Across Sleeves

Giving every sleeve in a multi-strategy book the same dollar capital sounds fair, but it isn't neutral in the way it looks. A sleeve trading low-volatility rates relative value will contribute far less risk to the overall book than a sleeve trading volatile small-cap equities, even with identical capital — so an "equal dollar" allocation is secretly a book dominated by whichever sleeve happens to be the most volatile.

Equal risk allocation fixes this by sizing each sleeve so it contributes the same amount of risk — usually measured as volatility or value-at-risk — to the total book, rather than the same amount of capital.

The mechanics

If sleeve A has an annualized volatility of 20% and sleeve B has an annualized volatility of 5%, giving them equal capital means sleeve A contributes four times as much risk to the portfolio as sleeve B. To equalize risk contribution, sleeve B needs roughly four times the capital of sleeve A. The simplest version of the calculation, ignoring correlation between the sleeves, is:

$$w_i \propto \frac{1}{\sigma_i}$$

In words: weight each sleeve inversely to its own volatility, so the more volatile a sleeve is, the less capital it gets — this alone equalizes each sleeve's standalone risk contribution, though a full version of the calculation also accounts for how the sleeves move together.

Worked example

A firm has two sleeves: a volatility-arbitrage sleeve at 24% annualized volatility, and a fixed-income relative-value sleeve at 6% annualized volatility. Under equal-dollar allocation with $10 million each, the vol-arb sleeve contributes four times the risk of the rates sleeve to the combined book. To equalize risk contribution, the firm instead allocates inversely to volatility: weights proportional to $1/24$ and $1/6$, which normalize to roughly 20% and 80% of capital. That means about $4 million to vol-arb and $16 million to rates relative-value — a far larger capital allocation to the "boring" sleeve, precisely because it needs more dollars to generate the same risk.

What this means in practice

Equal risk allocation is the standard starting point for multi-strategy books precisely because it stops the loudest, most volatile sleeve from silently dominating the portfolio's risk profile by default. It is a starting point, not an ending point — most desks then tilt away from pure equal-risk weights based on conviction, expected Sharpe ratio, or capacity constraints, but they tilt from an equal-risk baseline rather than from an equal-dollar one.