The Value of Portfolio Construction

Join us as Jason MacQueen, Honorary Lecturer at Lancaster University Management School and Founder of the London Quant Group, presents his paper on "The Value of Portfolio Construction" for this interactive virtual event on March 8, 2021.

Active portfolio management essentially consists of two steps: stock selection and portfolio construction. Many managers spend most of their time on stock selection, and then deal with portfolio construction by following some simple heuristic, such as equal-weighting or capitalisation-weighting. Most ETFs, for example, use one of these methods.

Unfortunately, this is virtually guaranteed to result in inefficient portfolios that make no attempt to trade-off expected return against risk, and which are therefore likely to have significant unintended bets.  The manager's stock selection skill can easily be dominated by the returns to these unintended bets.

In this presentation we use a simple stock selection rule (similar to those used to create some Style ETFs), and test a number of different methods of portfolio construction.  These will include equal-weighting, capitalisation-weighting, attribute-weighting, inverse volatility, risk parity and Markowitz optimisation.

The talk will also present a modified version of standard Markowitz optimisation, which is well-known to be quite problematic in practice.  Smart portfolio optimisaiton identifies the most inefficient holding in an existing portfolio and only allows a limited amount of trading in those stocks; the purpose is to gain a significant improvement in overall efficiency without incurring too many transaction costs.

Each of the strategies is rebalanced quarterly from the end of 2005 to the present.  Since the stock selection is always the same, the differences in performance and turnover are due entirely to the different methods of portfolio construction.  You may be surprised by the results.