How often do you think about the weights of the assets in your portfolio? Do you weigh your assets equally, or do you prefer value-weighting? The researchers behind a recent research paper analyzed various weighting schemes and examined their effect on factor strategy return. They studied five weighting schemes that ignore prices: equal weighting, rank weighting, z-score weighting, inverse volatility weighting, and fundamental weighting, and three price-based weighting schemes: Rank x mcap (rank-times-mcap), Z-score x mcap (z-score-times-mcap), and Integrated core.
They found that schemes that are not based on price can inflate turnover and costs. However, the weighting schemes based on price are the most practical to target multiple premiums, provide robust risk control, and decrease turnover and expenses.
Overall, the paper confirms a strong tie between market prices and security weights. The authors conclude that the weighting schemes which ignore prices result in uncontrolled deviations relative to the market. On the other hand, even though the price-based weighting schemes require additional expertise, they are a “must-have,” according to the authors. Additionally, the weighting schemes based on price effectively integrate multiple premiums.
Authors: Wei Dai, Namiko Saito, Gigi Wang
Title: Weighting for the Right One: Weighting Scheme Design for Systematic Equity Portfolios
Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4016481
Abstract:
We examine eight weighting schemes frequently used in the construction of systematic equity strategies. Through the lens of both returns- and holdings-based analysis, we highlight the importance of having a close link between security weights and market prices. Ignoring prices, as in the cases of equal weighting, rank weighting, z-score weighting, inverse volatility weighting, and fundamental weighting, can result in extreme and uncontrolled deviations relative to the market, as well as excessive turnover and costs. Furthermore, our analysis of three price-based weighting schemes identifies the integrated core approach as the most effective at targeting multiple premiums, ensuring robust risk control, reducing turnover and costs, and accounting for different investor objectives and practical considerations.
As always, we present several interesting figures:
Notable quotations from the academic research paper:
“A key aspect of a well-designed weighting scheme is the link between security weights and market prices. Current market prices reflect the latest news and aggregate expectations of market participants, providing real-time information about expected return differences across securities. By closely tying weights to prices, investors can effectively consider up-to-date information and target higher expected returns. Such a weighting scheme also acts as a robust risk control, allowing investors to directly manage the over- and underweights relative to market cap weights. Without a close tie to market prices, continuous price movements can drive up turnover and the costs of maintaining desired security weights. Price-based weighting schemes help limit those costs by continuously and gradually adjusting security weights as prices change.
Weighting Schemes That Ignore Prices
Price-Based Weighting Schemes
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