Factor Indexes and Factor Exposure Matching: Like-for-Like Comparisons
The academic literature tells us that for suitably diversified portfolios, factors drive risk and performance outcomes. If this is the case, then well-diversified portfolios with identical factor exposures should have similar performance characteristics despite originating from potentially very different construction methodologies. In this paper we test this hypothesis.
The simplest and most commonly employed factor portfolio construction technique is via selection and weighting (S&W). First one orders the stock universe by factor and then selects a proportion of the top rated stocks. The idea is that the more stringent the selection, the greater the factor characteristic captured. Stocks within this basket are then weighted according to the factor value itself or on some other criteria concerned with capacity (e.g. market cap weighting), diversification (e.g. equal weighting) or risk (e.g. risk weighting). This method has been employed by many practitioners and academics. Indeed some claim that combining certain weighting schemes yields the most efficient construction methodology in terms of the tradeoff between rewarded factor exposure and the diversification away of unrewarded risk.
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