engleski

An Application of Factor Based Approach to Efficient Portfolio Diversification in the Illiquid and Undeveloped Stock Market

In the past decade a variety of research analyzed the possibilities of moving away from inefficient cap-weighted benchmarks by empirically testing different “smart” beta strategies which aim to offer a more efficient harvesting of risk premium in the developed equity markets. While successful in the developed markets such strategies are not easy to implement in the undeveloped and illiquid markets in which it is hard to outperform the cap-weighted benchmark due to fewer investment opportunities and missing or unreliable data. In this paper we analyze the possibility of using fundamental weighting, a strategy criticized for exposing investors to additional and implicit risk factors, as a tool to intentionally tilt portfolio towards illiquid and undeveloped market’s specific and unobservable risk factors. In the second step we perform principal component analysis to capture the underlying risk factors of the fundamentally weighted portfolio and use them to optimize portfolio’s performance in the analyzed sample. We test 15 revisions of the cap-weighted CROBEX index in the period from 2009 to 2016 and find that the proposed approach significantly improves fundamental- weighting and outperforms the cap-weighting in the illiquid and undeveloped Croatian stock market. However, research results do not show the possibility of increasing the portfolio efficiency relative to the cap-weighted index by reducing its volatility which can be explained by exposure to additional risk factors. Still, the reported improvement should foremost be viewed in the context of a market in which both the naïve equal-weighting and the minimum volatility strategy failed and, therefore, did not yield results comparable to the developed markets.

efficient portfolio estimation, undeveloped and illiquid market, factor based approach

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