Bridge over ocean
17 June 2020 Financial Analysts Journal Volume 76, Issue 3

Risk Management and the Optimal Combination of Equity Market Factors

  1. Roger G. Clarke
  2. Harindra de Silva, CFA
  3. Steven Thorley, CFA

Combining factors in a multi-factor portfolio using forecast risk management can add substantially to returns. Backtesting showed such a strategy over 54 years earned annualized returns of 10.79%, vs. 7.77% for a similar non-risk-managed portfolio.

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 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.

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