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Article

Efficient Replication of Factor Returns: Theory and Applications

Dimitris Melas, Raghu Suryanarayanan and Stefano Cavaglia
The Journal of Portfolio Management Winter 2010, 36 (2) 39-51; DOI: https://doi.org/10.3905/JPM.2010.36.2.039
Dimitris Melas
is an executive director and head of European Equity and Multi-Asset Class Research at MSCI Barra in London, U.K.
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  • For correspondence: dimitris.melas@mscibarra.com
Raghu Suryanarayanan
is a senior associate and head of Alternatives Research EMEA at MSCI Barra in London, U.K.
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  • For correspondence: raghu.suryanarayanan@mscibarra.com
Stefano Cavaglia
is the chief executive officer at SCTR PTY LTD. in Hawthorne, QLD, Australia.
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  • For correspondence: sctrptyltd@gmail.com
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Abstract

This article presents alternative methods for constructing factor-replicating portfolios, which include portfolios that have unit exposure to a target factor, zero exposure to other factors, and minimum portfolio risk. The authors provide empirical evidence that constrained factor portfolios, with a limited number of assets and relatively low turnover, tracked several Barra equity risk model pure factor returns reasonably well. They also illustrate how factor-mimicking portfolios could have been utilized in the past to enhance both passive and active investment strategies. Factor-mimicking portfolios can be used to hedge out the unintended factor exposures of conventional benchmarks, which are aimed at targeting a particular beta factor, and thus enable plan sponsors to better manage their optimal allocations to beta factor risks. Additionally, factor-mimicking portfolios can be utilized to hedge out the style exposures of active stock-picking strategies enabling active managers to capture pure alpha.

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The Journal of Portfolio Management: 36 (2)
The Journal of Portfolio Management
Vol. 36, Issue 2
Winter 2010
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Efficient Replication of Factor Returns: Theory and Applications
Dimitris Melas, Raghu Suryanarayanan, Stefano Cavaglia
The Journal of Portfolio Management Jan 2010, 36 (2) 39-51; DOI: 10.3905/JPM.2010.36.2.039

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Efficient Replication of Factor Returns: Theory and Applications
Dimitris Melas, Raghu Suryanarayanan, Stefano Cavaglia
The Journal of Portfolio Management Jan 2010, 36 (2) 39-51; DOI: 10.3905/JPM.2010.36.2.039
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  • Article
    • Abstract
    • FACTOR-MIMICKING PORTFOLIOS: ANALYTICS
    • FACTOR-MIMICKING PORTFOLIOS: APPLICATIONS
    • IMPLICATIONS FOR PORTFOLIO MANAGEMENT
    • APPENDIX
    • ENDNOTES
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