Portfolio Scoring by Expected Risk Premium

Abstract

In this article, the authors discuss a general method for ranking portfolios that places few limitations on the portfolio constituents other than using publicly traded assets. The ranking scores reflect the expected reward investors would require for accepting the risks of the portfolio in the context of an asset pricing framework. The scores are computed through a factor model that acknowledges the factor return correlations. The authors illustrate the approach with a large universe of exchange-traded funds assuming a linear model with Fama–French–Carhart factors wherein factor premiums (i.e., expected returns) are proportional to factor volatilities. The empirical analysis implies that the most significant factors from the Fama–French–Carhart factor set driving the premiums are the market and the momentum factors.

TOPICS: Portfolio construction, analysis of individual factors/risk premia, exchange-traded funds and application