Hedged Portfolio Approach
The hedged portfolio approach was pioneered by Fama and French and can be used to identify factor performance. In particular, the approach can be used to create factors. Factors are variables or characteristics with which asset returns are correlated. Typical examples are the size and value factors introduced by Fama and French in 1993.
On this page, we discuss the steps needed to implement the hedged portfolio approach.
Hedged portfolio approach steps
The approach consists of the following set of steps:
- rank the investable stock universe by the factor (e.g. for the size factor, rank by market capitalization)
- divide the universe into quantiles. A quantile is a defined percentage proportion of the universe. For example, we might take the top 10% quantile for the size factor, which includes the 10% smallest companies. Typical quantiles are deciles (10%) or quintiles (20%).
- form a long/short portfolio by going long the best quantile and shorting the worst quantile. For the size factor based on deciles, this portfolio would buy the smallest 10% of the stock universe and short sell the largest 10% of the stock universe
- the performance of this long/short portfolio is tracked over time and represents the performance of the factor.
Drawbacks hedged portfolio approach
There are a number of drawbacks to this approach that are worth mentioning:
- the information in the middle quantiles is lost
- it is assumed that the relationship between the factor and stock return is linear
- portfolios can appear diversified when the manager uses multiple factors. These factors, however, can be highly correlated.
- the approach assumes the manager can short stocks
- the hedged portfolio is not a pure factor portfolio because it will typically have significant exposures to other risk factors.
An alternative approach is to use a factor mimicking portfolio. Such a portfolio has unit exposure to the factor and a zero exposure to all the other factors in the model.
Summary
We discussed how one can create factors by building portfolios of stocks that correlate highly to the factor under consideration.