Score-based Portfolio Choice

Abstract

In this paper, a score-based portfolio choice is introduced. We construct scores that are based on characteristics underlying the factor investing literature and apply these to a portfolio choice problem. The advantage of the score-based portfolio choice is that scores represent direct snapshots of balance sheet items and can therefore solve the problem of noisy factor sensitivity estimates in portfolio construction. We show that there exists an analytical solution for the score-based portfolio choice problem and find that significant excess returns can be achieved by implementing it. These excess returns can be attributed to the well-known risk factors of the factor investing literature. At portfolio construction, particular care needs to be taken when scores are implemented for characteristics with non-linear return contributions, as is the case for the book-to-market characteristic.

Keywords: Portfolio Choice, Factor Scores, Factor Investing, Portfolio Optimization