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

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 ofBrandt 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 theCarhart (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.