A Momentum Based Core Equity Strategy (Part 1)

June 9, 2016

Smart Beta strategies have become increasingly popular over the last few years.  These factor based strategies rank groups of stocks or certain characteristics that have proven to provide long-term outperformance over broad market benchmarks.  The strategies tend to be extremely disciplined in their stock selection processes, which has been one of the biggest knocks on active management over the years.

One of the best ways to use the idea of Smart Beta or Factor Investing is to combine them to form a core equity portfolio.  Individually, the factor portfolios often have greater volatility than the overall market.  But many of the factors have excess returns that are negatively correlated so you can combine individual factors together to lower the volatility of the portfolio.  The lower volatility can come with a nice benefit: the factor portfolios have the potential to generate better returns than the overall market.

I was working on another project that involved putting some factor data together so I decided to combine the portfolios into a Core Equity portfolio to see how it looked.  I’ll have a few posts on the blog that run through the steps and the data I used to create the factor strategies as well as the combined strategy.  Since I have developed a lot of momentum strategies over the years you will notice that most of what is going in to this model has a momentum bias.  I’m sure there are some other ways to go about this, but I have worked with the momentum factor for so long it is really easy for me to incorporate it into other factor based strategies.  I thought it would be a useful exercise to run through this process on the blog because we generally get some interesting feedback and suggestions on how to improve the processes.

There are quite a few factors out there, but we will really focus on a manageable number of four: Momentum, Low Volatility, Value, and Size.  I took care of the Size factor in the portfolio construction process.  All of the strategies are equally weighted, which gives them a small cap tilt over time.  I will revisit the effect of the equal weighting tilt at the end when I look at the combined portfolio.  It is easy to estimate the size effect by running a cap weight and an equal weight version of the same portfolio.

The other three factors really form the backbone of the core equity strategy.  In the next post I will discuss how those strategies where constructed and the historical performance of each factor portfolio.

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