Two Approaches to Factor-Based Portfolio Construction

Publisher: Lehman Brothers

Abstract:

Factor ranking-based portfolio construction is very common among equity quant PMs. Drawing on our previous work, this article summarises and gives practical guidance on our two approaches to factor-based equity portfolio construction: - • Ranking with skill (GK) methodology. Taking a factor ranking as input, we introduce a historical IC (i.e. skill) estimation method. This, together with our skill-based strategy combination method (Cheung and Vandermark, 2006a&b), address some frequently asked issues regarding the process.

Augmented Black-Litterman-based (ABL) methodology. Our ABL-based methodology (Cheung, 2007c) directly translates views on factor and stock returns into robust explicit stock return forecasts. By smoothly implementing factor views, style rotation issue is naturally resolved. Portfolio construction in this framework becomes visionary and robust.

This piece aims to put these two methodologies in parallel and give a brief and practical account of each. In a forthcoming article, we will explore the theoretical linkage between these two, and justify our preference.

Source: Manual