How to Choose a Strategic Multifactor Equity Portfolio?

Abstract

The authors present two strategic multifactor equity portfolios that combine four well-documented return sources: Value, Momentum, Quality, and Low Volatility to meet two distinct objectives. They propose a robust and flexible framework that uses the principles of modern portfolio theory and reduces the sensitivity to the estimation error. The paper should be of interest to your readers (and their clients) with longer investment horizons who look to allocate capital to factor indexes.

Among other considerations, the authors believe investors can choose to focus on active risk return tradeoffs or absolute risk return tradeoffs. That is why, in this paper, they present two Strategic Portfolios: IR Portfolio (Information Ratio Portfolio) and SR Portfolio (Sharpe Ratio Portfolio). Their framework moves away from single-point estimates and captures the high-level relationships of return sources through a ranking approach. These high-level relationships have shown to hold over time and allow for consistent exposures over time. They also present the results for alternative weighting schemes, such as equal-weight, minimum variance, maximum diversification, minimum correlation, and risk parity.

TOPICS: Mutual funds/passive investing/indexing, analysis of individual factors/risk premia, portfolio theory