Factor Tilting for Expected Utility Maximization

Abstract

We investigate a strategy of investing in diversified portfolios with a historically optimal factor profile, which we refer to as ‘factor tilting’. The proposed approach approximates the optimal strategy for risk-averse investors under the assumptions of Arbitrage Pricing Theory. Moving beyond traditional mean-variance optimization, it allows the incorporation of any characteristic of the return distribution for a large number of stocks. We propose extensions to incorporate transaction costs and test factor significance.

Keywords: active portfolio management, factor models, arbitrage pricing theory, parametric portfolio policies

JEL Classification: G12, G15