Quants Find the Missing Piece

New research has found that the implementation methods related to some factor-based investing strategies is the culprit for underperformance, and that “a simple formula can solve it.” This according to an article in Institutional Investor.

The study reportedly analyzed the best way to combine investment factors like value and momentum and found that a portfolio constructed using “forecast risk management”—a formula that “determines the weights of an optimal multi-factor portfolio with risk management”—could generate “significant excess returns”—of 10.79 percent versus 7.77 percent for a similar portfolio.

In an interview with II, one of the study’s authors, Brigham Young University finance professor Steven Thorley, explained, “When you construct a multi-factor portfolio it is a complicated process, with lots of decisions  such as which stocks to include and how to weight them if they are included. Some of the methodologies are ad hoc, with arbitrary decisions being made. That just creates noise. Lately, those implementation issues have been a drag.”

Thorley said that the new methodologies applied in the research study “make it simple and straightforward” and he is hopeful that asset managers will adopt them. “People are looking for some answers,” he said, which, “might be enough to make its adoption more widespread.”