### Suppressing Unrelated Risks from Stock Factor Portfolios

**February 3, 2017** - Equity Premium, Momentum Investing, Size Effect, Value Premium, Volatility Effects

Does suppressing unrelated risks from stock factor portfolios improve performance? In their January 2017 paper entitled “Diversify and Purify Factor Premiums in Equity Markets”, Raul Leote de Carvalho, Lu Xiao, François Soupé and Patrick Dugnolle investigate how to improve the capture of four types of stock factor premiums: value (12 measures); quality (16 measures); low-risk (two measures); and, momentum (10 measures). They standardize the different factor measurement scales based on respective medians and standard deviations, and they discard outliers. Their baseline factors portfolios employ constant leverage (CL) by each month taking 100% long (100% short) positions in stocks with factor values associated with the highest (lowest) expected returns. They strip unrelated risks from baseline portfolios by:

- SN – imposing sector neutrality by segregating stocks into 10 sectors before ranking them for assignment to long and short sides of the factor portfolio.
- CV – replacing constant leverage by each month weighting each stock in the portfolio to target a specified volatility based on its actual volatility over the past three years.
- HB – hedging the market beta of the portfolio each month based on market betas of individual stocks calculated over the past three years by taking positions in the capitalization-weighted market portfolio and cash.
- HS – hedging the size beta of the portfolio each month based on size betas of individual stocks calculated over the past three years by taking positions in the equal-weighted market portfolio and the capitalization-weighted market portfolio.

They examine effects of combining measures within factor types, combining types of factors and excluding short sides of factor portfolios. They also look at U.S., Europe and Japan separately. Their portfolio performance metric is the information ratio, annualized average return divided by annualized standard deviation of returns. Using data for stocks in the MSCI World Index since January 1997, in the S&P 500 Index since January 1990, in the STOXX Europe 600 Index since January 1992 and in the Japan Topix 500 Index since August 1993, all through November 2016, *they find that:* Keep Reading