To read Part 1 click here
To read Part 2 click here
To read Part 3 click here
The Core Equity strategy uses the three factor strategies discusses in Part 3. In order to keep things as simple and non-optimized as possible I just included each model at a 1/3 weight of the total portfolio. However, by using three different models you can adjust the weightings of each one to suit the end investor’s needs. For example, if you needed less volatility you can just increase the weight of that model in the combined portfolio.
The Core Equity strategy is rebalanced monthly just like the individual factor models are. Since a stock can be included in more than one of the factor models, the final model isn’t necessarily 300 stocks with equal weights. Some stocks will have larger weights than others because they are in multiple models. That is the only weighting difference though – there is no market capitalization or factor adjustment made to the stock weightings.
In order to judge the fourth factor, size, I modified the final portfolio construction process to account for market cap. Each stock’s market cap along with how many of the three factor models it was in was taken into account. A mega cap stock in only one of the factor models might have a higher weight than a smaller cap stock in multiple models in this scenario. Generally speaking, market capitalization weighting is sub-optimal for investment returns (not for capacity) and that is one big reason why Smart Beta has taken off. We see the same thing here when we adjust for market cap.
The returns for the final Core Equity strategy add significant value over the broad market while keeping the volatility (standard deviation) close to that of the benchmark (below for a cap weight version of the Core Equity strategy). More importantly, it helps smooth out the ride of the individual factor models. In 1999, for example, Low Volatility was a large underperformer, but momentum was strong enough to carry the overall portfolio to strong returns. Just two years later in 2001, the roles were reversed and it was Low Volatility and Value picking up the slack for the poor momentum returns. You can see similar things happening in years like 2006, 2007, and 2011. I think this point is vastly underrated because investors tend to abandon strategies at exactly the wrong times – after they have underperformed and are due for a rebound. Combining all three factor strategies into one large Core Equity portfolio helps mask the underperformance of specific factor models and helps investors stay with underperforming strategies.
There are probably an infinite number of ways you can construct a core equity strategy using different factors. Here, I have looked at just one that was designed to be extremely simple, non-optimized, and robust going forward. I used some custom models to create the underlying factor models, but they shouldn’t be so dramatically different from existing ETF’s or mutual funds that something similar couldn’t be done on a smaller scale. I’m sure there are better ways to construct the factor models and put them together in the final Core Equity strategy. If you have any ideas about how that can be done I would love to hear them!
The returns used within this article are the result of a back-test using indexes that are not available for direct investment. Returns do include dividends, but do not include transaction costs. Back-tested performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes to illustrate the effects of the discussed strategy during a specific period. Back-tested performance results have certain limitations. Such results do not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. Back-testing performance also differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight. Dorsey, Wright & Associates believes the data used in the testing to be from credible, reliable sources, however; Dorsey, Wright & Associates, LLC (collectively with its affiliates and parent company, “DWA”) makes no representation or warranties of any kind as to the accuracy of such data. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.