Journal of Investment Strategies
ISSN:
2047-1238 (print)
2047-1246 (online)
Editor-in-chief: Ali Hirsa
Value-ranked equity portfolios via entropy pooling
Josef Zorn
Need to know
- This article shows how to synthesize mean-variance efficiency with value investing.
- Multiple value rankings are merged with the market by minimizing the relative cross-entropy.
- This approach allows for smoothly blending a mean-variance efficient portfolio to a desired value factor exposure.
- Resulting portfolios gain both from diversification and the predictive content in value rankings.
Abstract
This paper demonstrates how to directly incorporate common value-investing ideas into the portfolio optimization process. Through minimizing the relative entropy, multiple value rankings are merged with the historical return distribution. This approach yields performance improvements from both a diversification and a predictive perspective across various international stock markets. The predictive component can be attributed to a specific value tilt of the portfolios. Increasing the confidence in the value rankings smoothly exposes a portfolio to the desired value factor.
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