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27 June 2023 Financial Analysts Journal Volume 79, Issue 3

Factor-Targeted Asset Allocation: A Reverse Optimization Approach

  1. Jacky S.H. Lee
  2. Marco Salerno
The authors propose a method for constructing robust asset portfolios based on factor exposures implied by a mean–variance optimal portfolio.
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We demonstrate that using a mean-variance portfolio to obtain implied factor risk premia can result in stable weights for a factor portfolio when assets’ expected returns follow a factor structure that is subject to pricing errors. We propose a methodology to construct asset portfolios based on these factor portfolio weights, taking into account the possibility of pricing errors. Our simulation shows that these “factor-targeted” portfolios have higher and more stable Sharpe ratios than traditional allocation methodologies in various scenarios involving expected return assumptions. Furthermore, while our factor-targeted portfolios exhibit similar Sharpe ratios to the mean-variance portfolio built using factors for high levels of pricing errors, the factor-targeted portfolios have more stable portfolio weights, which makes them more appealing in practice.

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