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| Type | Master's Thesis |
| Scope | Discipline-based scholarship |
| Title | Strategic Allocation to Return Factors |
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| Institution | University of Zurich |
| Faculty | Faculty of Business, Economics and Informatics |
| Number of Pages | 80 |
| Date | 2016 |
| Zusammenfassung | Diversification is one of the most fundamental concepts in asset management theory and practice. However, during the financial crisis many private and institutional investors with diversified portfolios suffered big losses across all asset classes. The increased correlations among asset classes during big economic downturns offset diversification effects. As a result, Bhansali (2011) argued, that investors would be better off by diversifying their exposure across risk factors instead of asset classes. Risk premiums try to explain the fundamental economic rationale for positive excess returns but it is very difficult to find a common framework for their meaningful allocation in portfolios. A pragmatic approach combines empirically proven return sources such as beta, value, momentum, carry and volatility into a strategic allocation and may offer superior diversification benefits. Such “return factors” allow for more straight forward investment proxies and allocation rules than risk premiums. The existing literature focused more on the identification of individual sources of returns than on the explanation of different portfolio construction approaches for return factor portfolios. On the other hand, there are plenty of studies which document portfolio construction methods for traditional asset class portfolios. Ilmanen and Kizer (2012) showed that a portfolio determined by various strategy styles offers better diversification benefits than an asset class diversified portfolio. They formed portfolios according to an equal weighted and an equal volatility weighted approach. The equal volatility weighted approach produced a higher Sharpe ratio. This thesis aims to extend the framework of Ilmanen and Kizer (2012) by analyzing different approaches to construct portfolios consisting of well-known return sources. In a first step, proxies which track the performance of selected return sources will be described and their market characteristics will be analyzed. The thesis focuses on beta, value, momentum, carry and volatility as return sources. Many of these return sources can be harvested across various asset classes (see Asness, Moskowitz & Pedersen. (2013) and Koijen et al. (2015)). In a second step, the individual return factors will be combined into portfolios based on the following approaches: Equal weighting, mean variance optimization (Markowitz (1952)), risk parity (Mailard, Roncalli & Teiletche (2008)), most diversified portfolio (Choueifaty & Coignard (2008)) and relative carry (Evstigneev, Hens & Schenk-Hoppé (2016)). The return factor portfolios will be compared to a benchmark portfolio consisting of a traditional asset class allocation. The empirical analysis - using available market data over a 20-year period starting in 01.1995 until 12.2015 - leads to the conclusion that strategic allocations defined directly across various return sources have several advantages over a traditional allocation across asset classes. The inclusion of various return sources beyond beta increases Sharpe ratios, lowers drawdowns and leads to allocations which are better diversified across macroeconomic shocks. The various portfolio construction approaches do not show dramatically different Sharpe ratios in the long run. However, comparing the Sharpe ratios during different economic environments shows significant variations. The lowest variation and hence the most robust returns were found for the risk parity portfolio. The asset management industry would be well advised to consider returns beyond beta, given the strong results of return factor allocations. However, the strategies discussed in this thesis are complex to implement and supervise. In addition, the use of leverage, derivatives and short positions is not suitable for many investors. Politically driven economic parameters (such as quantitative easing and negative interest rates over a long period) may lead to different results. In the academic literature exist little consensus regarding which return factors should be considered and whether they will continue to be profitable in the future. Further research on this topic might be needed before strategic allocations across return factors can be considered for the broad investment audience. |
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