Articles from Cass Knowledge

How the Equal-Weight Integration approach compares favourably to other Style-Integration investment methods

Investors seeking attractive returns at relative low-risk have been presented with a bewildering array of long-short investment approaches (or styles) by academic studies.

The task of choosing one style over another is all the more challenging because past performance is no guarantee of future performance.

Various studies have suggested an integration of styles - to simultaneously exploit diverse characteristics towards the construction of a unique portfolio with multiple style exposures that enhances the performance of the underlying standalone-style portfolios.

However, there are different methods for forming a style-integrated portfolio and to date there has been no attempt to appraise them comparatively in a self-contained paper.

The study A Comprehensive Appraisal of Style-Integration Methods addresses this gap by providing a comprehensive appraisal and comparison of seven style-integration methods. It confronts the naïve Equal-Weight integration (EWI) method with a host of ‘sophisticated’ style-integrations that derive the style exposures using past data according to utility maximization, style rotation, volatility timing, cross-sectional pricing, style momentum or principal components criteria.

It considers a risk-averse investor who implements their allocation decisions on futures contracts instead of the underlying assets; futures markets offer the advantages of deep liquidity, no constraints on shorting, and low transaction costs.

The out-of-sample performance of the style-integration methods separately in equity index, fixed income, currency and commodity futures markets is studied. To provide rigorous evidence, the analysis is also implemented for diversified portfolios that include all four futures classes.

It finds that the EWI approach is the most appealing style-integration method. This approach is very easy to deploy as no parameter estimation is required. It also affords a reward-to-risk profile that is unsurpassed by that of alternative style-integrated portfolios. The inability of the sophisticated style-integration portfolios to outperform the EWI portfolio indirectly suggests that the benefits from allowing time-varying and heterogeneous style-weights are offset by parameter estimation error and representativeness heuristic bias.

The key finding here is that the EWI approach is unsurpassed by sophisticated style-integration methods per futures class (equity, fixed income, currency and commodity) and across (futures) classes.

This research adds to the literature on forecast combination, where the equal-weight forecast combination approach has become the de facto benchmark against which any newly developed forecast combination method is appraised.

By equally weighting all styles constantly over time, it is possible to construct a more attractive return-to-risk portfolio profile than by focusing on one style or by integrating the styles in a more sophisticated fashion that requires data-based weight estimation.

This paper has been published in Journal of Banking & Finance. A copy of the paper can be requested at City Research Online.