Portfolio Construction Matters

Abstract

The role of portfolio construction in the implementation of equity market neutral factors is often underestimated. Taking the classical momentum strategy as an example, the authors show that one can significantly improve the main strategy’s features by properly taking care of this key step. More precisely, an optimized portfolio construction algorithm allows one to significantly improve the Sharpe ratio, reduce sector exposures and volatility fluctuations, and mitigate the strategy’s skewness and tail correlation with the market. These results are supported by long-term, worldwide simulations and are shown to be universal. The authors’ findings are also general and hold true for a number of other equity factors. Finally, the authors discuss the details of a more realistic setup in which they also deal with transaction costs.

TOPICS: Portfolio management/multiasset allocation, portfolio theory, portfolio construction

Key Findings

• • Portfolio construction plays a key role in the implementation of equity market neutral strategies.

• • The Markowitz solution, when the correlation cleaning is correctly taken care of, leads to better results for the most well-known equity factors.

• • The Markowitz approach furthermore allows for a generalization of the optimization problem, which takes these costs into account.