Risk Optimizations on Basis Portfolios: The Role of Sorting

Abstract

This paper investigates the mean-variance and diversification properties of risk-based strategies performed on style or basis portfolios. We show that the performance of these risk strategies is improved when performed on portfolios sorted on characteristics correlated with returns and is highly sensitive to the sorting procedure used to form the basis assets. Whereas the extant literature provides mixed support for the outperformance of smart beta strategies based on scientific diversification, our designed strategies outperform both the market model and multifactor models. Our testing framework is based on bootstrapped mean-variance spanning tests and shows valid conclusions when controlling for multiple testing, transaction costs, and luck from random basis portfolio construction rules. Economically, our results are supported by diversification-based properties.

Keywords: Bootstrap, Mean-variance efficiency, Portfolio sorting, Risk-based optimization, Smart Beta, Style investing.

JEL Classification: G10, G11