Risk Management and the Optimal Combination of Equity Market Factors
Financial Analysts Journal, 2020, 76(3): 57–79.
Posted: 14 Nov 2019 Last revised: 17 Aug 2020
Date Written: February 25, 2020
Managing the intertemporal risk of optimally constructed multifactor portfolios adds to performance. The increases in Sharpe ratios are in addition to the utility that investors gain from controlling how much active risk they are exposed to over time. We derive a simple closed-form formula for security weights in optimal multifactor portfolios with an active-risk target. We test the risk control of five well-known factors—value, momentum, small size, low beta, and profitability—and the optimal multifactor portfolio. Our empirical research was carried out on the large-capitalization US equity market for 1966 through 2019. We conclude that for the equity market, more active factors are better than fewer if each factor subportfolio is “pure” as to factor, anchored to the benchmark, and combined on the basis of forecastable risks. Our portfolio construction methodology allows for transparent performance attribution and replication of the process in other markets and time periods.
Keywords: Factor Investing, Risk Management
JEL Classification: G11
Suggested Citation: Suggested Citation