Clash of the Titans: Factor Portfolios versus Alternative Weighting Schemes

Abstract

In this article, the authors (re) introduce mean–variance portfolio construction for factor portfolios. These models, first popular with quants in the 1990s, are being resurrected today in a different context for transparent factor portfolios. The authors then evaluate the merits of these mean–variance factor portfolios against alternative weighting schemes. They point out that alternative weighting schemes have arguably weak theoretical foundations, and their supporters rationalize them with a range of (very different) reasons, most of them dissatisfying in the view of the authors. They then show that alternative weighting schemes derive a large part of their outperformance from a handful of well-known factors. The authors argue that sensibly built factor portfolios deliver a similar or higher information ratio by explicitly harnessing the factors and doing so in an efficient risk- and transaction cost-aware way.