Abstract
AbstractFactor‐based allocation embraces the idea of factors, as opposed to asset classes, as the ultimate building blocks of investment portfolios. We examine whether there is a superior way of combining factors in a portfolio and provide a comparison of factor‐based allocation strategies within a multiple testing framework. Factor‐based allocation is profitable beyond exploiting genuine risk premia, even when applying multiple testing corrections. Investment portfolios can be efficiently diversified using factor‐based allocation strategies, as demonstrated by robust economic performance over various economic scenarios. The naïve equally weighted factor portfolio, albeit simple and cost‐efficient, cannot be outperformed by more sophisticated allocation strategies.
Highlights
We thank two anonymous referees, Geert Bekaert, John Doukas, Tizian Otto, Tatjana Puhan, and Henning Schröder for helpful comments
The stable performance of factor‐based portfolios across varying. This table reports the performance statistics of a cash investment, the equity market portfolio (MKT), and total return portfolios consisting of a 100% position in cash with a zero‐dollar position in a factor portfolio net of turnover‐dependent transaction costs of 50 basis points over the evaluation period from January 2006 to December 2019: annualized arithmetic mean of monthly returns (Mean), annualized standard deviation (SD), Sharpe ratio (SR), maximum drawdown (MDD), average portfolio turnover (TO), and average diversification ratio (DR)
We establish that factor‐ based allocation is profitable, even when implementing the necessary multiple testing corrections
Summary
Building on the seminal work of Markowitz (1952), investors have traditionally focused on diversifying across broad asset classes, such as equities and bonds, when building their investment portfolios in order to balance risks and rewards. We contribute to the literature on factor investing by asserting that factor‐based allocation is relatively easy to implement using tradable instruments; by showing that such strategies earn significant risk‐adjusted excess returns relative to the market; and by demonstrating that it is difficult to beat an weighted factor portfolio, thereby providing guidance on the best method(s) to choose when constructing factor‐based portfolios (Koedijk et al, 2016a). Our analysis is closely related to the recent literature on optimization methods (Bessler & Wolff, 2015; De Miguel, Garlappi, & Uppal, 2009; Hsu, Han, Wu, & Cao, 2018; Kritzman, Page, & Turkington, 2010) and applies previously researched methods to a new data set, that is, global equity and fixed income factor premia that most investors can invest in.
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