Portfolio Construction Matters

TL;DR

This paper demonstrates that proper portfolio construction significantly enhances the performance and risk profile of equity market neutral strategies, such as momentum, across various settings and factors.

Contribution

It introduces an optimized portfolio construction algorithm that improves strategy metrics and demonstrates its universality across multiple equity factors.

Findings

Improved Sharpe Ratio with optimized construction

Reduced sector exposures and volatility fluctuations

Mitigation of skewness and tail correlation

Abstract

The role of portfolio construction in the implementation of equity market neutral factors is often underestimated. Taking the classical momentum strategy as an example, we show that one can significantly improve the main strategy's features by properly taking care of this key step. More precisely, an optimized portfolio construction algorithm allows one to significantly improve the Sharpe Ratio, reduce sector exposures and volatility fluctuations, and mitigate the strategy's skewness and tail correlation with the market. These results are supported by long-term, world-wide simulations and will be shown to be universal. Our findings are quite general and hold true for a number of other "equity factors". Finally, we discuss the details of a more realistic set-up where we also deal with transaction costs.