Pure Quintile Portfolios

Abstract

In this article, the author proposes a new portfolio construction framework called “pure quintile portfolios.” These portfolios overcome the main drawback of naïve quintile portfolios based on single sorts—namely, not having pure exposures to the target factor. Each pure quintile portfolio has the same exposure to the target factor as its naïve counterpart, but also has zero exposures to all other factors. Therefore, pure quintile portfolios more accurately reflect the cross-sectional distribution of true factor returns. In addition, when the author goes long Q1 and short Q5 to capture factor premia as is most commonly done in research and practice, he finds that the pure Q1–Q5 portfolio has lower risk and a higher Sharpe ratio than the naïve Q1–Q5 portfolio for a group of widely used factors. According to the author, this shows that his new framework is more efficient at capturing factor premia than naïve quintile portfolios.

TOPICS: Portfolio theory, analysis of individual factors/risk premia