Hierarchical Equal Risk Contribution

Also seen as: HERC, equal risk per group

How does it differ from Hierarchical Risk Parity?

Two things change, and both follow the groups more faithfully.

• Where the cut falls. Hierarchical Risk Parity halves a list, so a cut can land in the middle of a real group. Hierarchical Equal Risk Contribution cuts where the tree branches: if 30 instruments split naturally into 22 cyclical stocks and 8 defensive ones, the first split is 22 against 8, not 15 against 15.
• How each split is shared. Each side gets a share that makes the two sides' risk contributions equal, which for two sides means sharing in inverse proportion to their volatility:

where: $\sigma_{\text{left}}$ and $\sigma_{\text{right}}$ are the volatilities of the two branches, and $w$ is each branch's share of the capital above it. Because $w \times \sigma$ comes out the same on both sides, each branch supplies an equal slice of the risk — the Risk Parity idea applied one split at a time.

In universes where the instruments are only loosely correlated, the two methods give similar weights; the difference grows when strong groups exist.

How does Fincanva handle it?

• Hierarchical Equal Risk Contribution is offered inside a single strategy only, across its instruments; a Combined does not offer it.
• It has no settings of its own. It reads the calculation window (In-sample, 12 months by default) and the Risk estimation choice — see Risk estimation.
• Weights are never negative.
• With most risk estimates — including the recommended Ledoit-Wolf · constant correlation — every instrument must have moved in price at some point inside the window: an instrument whose price stayed flat for the whole window, such as a suspended listing, stops the backtest rather than receiving a weight. Two estimates are the exception; Risk estimation names them.
• Weights are recomputed at every rebalance from the window ending on that date.

Which plan includes Hierarchical Equal Risk Contribution?

Included from Advanced upwards. See what each plan includes.

What does it look like in practice?

Take the same four instruments as on the Hierarchical Risk Parity page: an equity pair with 20% volatility and a bond pair with 10%, each pair made of two funds of equal risk.

• First split, equities against bonds: the equity branch receives (1 ÷ 0.20) ÷ (1 ÷ 0.20 + 1 ÷ 0.10) = 5 ÷ 15 = 33.3%, and the bond branch 66.7%. Check: 33.3% × 20% = 66.7% × 10% ≈ 6.7% — equal risk on both sides.
• Second split, inside each pair: two funds of equal risk share their branch evenly, so each equity fund gets 16.7% and each bond fund 33.3%.

The result is 16.7% / 16.7% / 33.3% / 33.3%. Hierarchical Risk Parity, splitting by variance instead of volatility, gave the same tree 10% / 10% / 40% / 40% — a heavier tilt toward the calmer branch.