Dynamic Risk Management of Equity Market Factors
38 Pages Posted: 14 Nov 2019 Last revised: 24 Dec 2019
Date Written: November 11, 2019
Managing the inter-temporal risk of multi-factor portfolios adds to performance in addition to the utility investors gain from controlling how much risk they are exposed to over time. We derive a simple closed-form formula for security weights in optimal multi-factor portfolios with an active risk budget. We test the risk control of five factors; value, momentum, small size, low beta, and profitability, and the optimal multi-factor portfolio. Our empirical research on the large-cap U.S. equity market over the last 54 years (1966 to 2019) allows for transparent performance attribution and replication of the process in other markets and time periods. We conclude that for the U.S. equity market, more active factors are better than less if each factor sub-portfolio is pure and anchored to the passive benchmark. Dynamic management of multi-factor portfolio exposures controls the level of active risk over time and increases realized performance.
Keywords: Factor Investing, Risk Management
JEL Classification: G11
Suggested Citation: Suggested Citation