Stock Portfolio Optimization

Measuring and Tuning Factor Exposure

July 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Portfolios frequently contain stocks representing duplicate factor risks or insignificant weights
  • An optimisation process focused on factor exposure can increase the portfolio efficiency
  • Increasing or decreasing factor exposure requires a view on expected factor performance and risks

INTRODUCTION

Gardens tend to lose their curated design quickly, if not cared for constantly, as grass, bushes and trees grow according to nature’s will. Stock portfolios share this feature as they can look dramatically different, if left unattended for a period of time. Some stocks might dominate in size, others become insignificant and some just represent duplicate risks. However, investors have a variety of tools at hand to keep portfolios in shape. In this short research note we will investigate the application of an optimisation process for an investor targeting to increase the Value factor exposure of a stock portfolio with a Quality focus while improving the overall portfolio efficiency (read Value+Quality or High Quality Value Stocks).

METHODOLOGY

We measure the exposure of the stock portfolio to seven common equity factors namely Value, Size, Momentum, Low Volatility, Quality, Growth and Dividend Yield in the US stock market. The factor definitions are in line with industry standards and the factor exposure is measured ranking-based, i.e. each stock is ranked on each factor relative to all other stocks and then assigned a ranking score, which is then aggregated on portfolio level for each factor.

FACTOR EXPOSURE ANALYSIS

As a first step we conduct a factor exposure analysis of the current portfolio, which can be seen in the chart below. Unsurprisingly, the analysis reveals high exposure to the Quality factor, which is defined as a combination of return-on-equity and debt-to-equity metrics (read Quality Factor: How To Define It?). We can also observe positive exposure to Growth and Momentum as well as negative exposure to Value, Dividend Yield and Low Volatility. It is quite typical that portfolios with specific factor tilts exhibit significant e