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Dispatches Stock Strategies

Improving the Efficiency of Multifactor Stock Strategies

Researchers worked on a methodology to limit the economic risks of stock-picking strategies that are based on combining factors.

by Tudor Pop | October 2024

Researchers worked on a methodology to limit the economic risks of stock-picking strategies that are based on combining factors.

In this methodology, a weighting scheme called EconRisk is applied to the six factors determined by academics to be robust: size, value, momentum, volatility, profitability and investment. Economic risks such as supply chain disruptions, trade tensions, monetary policy changes and geopolitical events are identified. Each factor’s weight in the multifactor strategy is allowed to deviate based on its exposure to these risks. In addition to reducing economic risks, the weighting eliminates unnecessary tracking error by keeping strong exposures to the factors and preserving diversification benefits.

The researchers also found that introducing their EconRisk weighting scheme to the diversified multifactor strategy reduces sector deviations relative to a market-capitalization-weighted benchmark.

Reduction in Sector Deviation

The study concluded that EconRisk is a robust portfolio construction approach to dampen economic risks of diversified multifactor strategies while retaining their attractive expected returns. The approach reduces unnecessary tracking errors, resulting in more efficient multifactor portfolios. It does this by capturing stronger exposure to the factors for the same level of deviation relative to a market-cap-weighted benchmark.

Investors need to recognize the importance of economic risks on the short-term variability of factor portfolios’ returns and adapt their stock-picking strategies. The management of economic risks via the EconRisk approach is one possible way to add value for investors looking to build diversified portfolios based on multiple factors.

Source: “Mitigating Economic Risks in Multi-Factor Strategies,” by Joseph Simonian, Ph.D.; CFA Institute Enterprising Investor blog, August 19, 2024.

Discussion

JOHN L from NJ posted almost 2 years ago:

Another back tested scheme to beat the market! If the future turns out to be just like the past this will lead to superior results. But what are the odds that the future isn't like the past?


ROBERT A from NC posted almost 2 years ago:

You lost me at "volatility." Volatility is an intelligent investor's FRIEND; it has NOTHING to do with risk!


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