Efficient Replication of Factor Returns: Theory and Applications

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.

TOPICS: Portfolio construction, analysis of individual factors/risk premia, factor-based models