An investor’s perspective on risk-models and characteristic-models

Abstract

Purpose In capital markets, research risk factor loadings and characteristics are considered as opposing explanations for the cross-sectional dispersion in average stock returns. However, there is little known about the performance an investor would obtain who believes either in the characteristics explanation (CB-investor) or in the risk factor loadings explanation (RB-investor). The purpose of this paper is to compare the performance of CB- and RB-investors. Design/methodology/approach To compare the competing strategies, the authors propose a simple new approach to equity portfolio optimization in the style of Brandt et al. (2009) by modeling the portfolio weight in each asset as a function of the asset's risk factor loadings or characteristics. The authors perform an empirical analysis on the German stock market, exploiting the risk factor loadings from the Carhart (1997) four-factor model and the respective characteristics size, book-to-market equity ratio and momentum. Findings The results show that investment strategies relying on characteristics (particularly on momentum) outperform risk-based investment strategies in horse races. These findings hold in- and out-of-sample. Furthermore, the characteristics-based investment strategies outperform a value-weighted market portfolio strategy in- and out-of-sample. Originality/value The authors introduce a portfolio optimization approach that enables investors to directly link portfolio decisions to the firm’s characteristics or risk factor loadings.

Risk models vs characteristic models from an investor’s perspective

“…The results from Kim (2015) indicate that risk factor models outperform their characteristic-based counterparts. Another approach is taken by Fieberg et al (2016a). They relate various risk and characteristic models to the distribution of portfolio returns but thereby only implicitly relate these models to expected stock returns and the variance-covariance matrix itself.…”