Tail Behavior in Portfolio Optimization for Equity Style Factors

Abstract

Diversification has been long considered an essential part of investing for the long term. Our paper aims to look further on portfolio diversification and how asset allocation can be optimized. We suggest that the selection of investments in a portfolio should be based on how the market behaves subject to extreme events or in other words on tail behavior. Firstly, we look at equity style factors and how they perform in the worst 10 scenarios of the market. Second, we regress ETF factor-based indices on these style factors and evaluate how much of the indices’ performance can be explained. We then construct a hypothetical portfolio and suggest a portfolio optimization strategy which takes into consideration how its assets are behaving in bad times of the market economy. Our results indicate that style factors offer diversification benefits during distress periods. As a consequence, they comprise a useful source of information when we wish to optimize the asset allocation of our portfolio.

Keywords: optimization techniques; tail events; smart beta; asset allocation model; diversification; stock market returns

JEL Classification: C6; C19; G10; G11; G15