Risk optimizations on basis portfolios: The role of sorting

Abstract

This paper investigates the mean–variance and diversification properties of risk-based strategies executed on style or basis portfolios. We show that the performance of these risk strategies is highly sensitive to the sorting procedure used to form the basis assets. Whereas the extant literature provides mixed support for the outperformance of smart beta strategies based on scientific diversification, our designed strategies outperform both the market model and multifactor model. Our testing framework is based on bootstrapped mean–variance spanning tests and shows valid conclusions when controlling for multiple testing, transaction costs, and luck from random basis portfolio construction rules. Economically, our results are supported by diversification-based properties. • The dependent sorting procedure improves the efficiency of basis portfolios. • Low-risk optimizations on dependent basis portfolios outperform traditional portfolios. • Maximum diversification and minimum variance deliver very strong outperformance. • Smart betas on dependent portfolios span a larger set of traditional portfolios.