Moderate restrictions do not, in general, reduce a portfolio’s exposure to systematic risk. This is both good news and bad news. Constraints on portfolio construction do not shield funds from certain risks as they’re intended to. But, constructed thoughtfully, a constrained portfolio can capture similar levels of alpha to its unconstrained counterparts.
The white paper proposes a smart portfolio construction framework to build constrained equity portfolios which can achieve similar levels of alpha as the unconstrained counterparts:
1. Different sources of alpha can be combined in the portfolio and the level of risk allocated to each of them can be properly budgeted.
2. When sources of alpha are systematic styles like value, momentum, low volatility or small capitalization stocks, the approach proves more robust than existing Smart Beta indices which often combine them in a clumsy way likely to cost some performance.
3. The handling of constraints has been designed to make sure that they have the smallest possible impact in the portfolio. Our results show that the final constrained portfolio still performs as well as its unconstrained counterparts when moderate levels of constraints are imposed, e.g. no short-selling.
4. We built a number of global equity model portfolios with three different levels of constraints: none; long-only plus liquidity constraints; and long-only plus liquidity constrains plus a capped number of stocks. Using three different risk-budgeting allocation approaches to combine alpha sources including mean variance, maximum diversification, and equal-risk weighting we show that constraints have little impact on the portfolio performance or their exposure to systematic risk factors when the sources of alpha are style tilts in favour of value, momentum, small-capitalization and low volatility stocks.
Thought leadership at BNP Paribas Investment Partners
BNP Paribas Investment Partners considers Thought Leadership to be a key ingredient of its value proposition to its clients. It underpins its innovation effort in terms of products and client solutions. Thought Leadership is a company-wide effort and is built on the interaction between management, the salesforce, research and investment teams, marketing and fund engineering. The white paper on Multi-Alpha Equity Portfolios is the third in a series of white papers which are produced by BNP Paribas Investment Partners in an effort to assist its clients in their investment decisions.
