What difference do the new factor models make in portfolio allocation?

• Main Authors: Fabozzi, Frank J., HUANG, Dashan, Jiang, Fuwei, WANG, Jiexun
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2024
• Subjects: Portfolio allocation; Mean-variance analysis; Factor model; Asset pricing; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/5232; https://ink.library.smu.edu.sg/context/lkcsb_research/article/6231/viewcontent/NewFactorModel_PA_202311_sv.pdf
• Institution: Singapore Management University

This paper compares the Hou-Xue-Zhang four-factor model with the Fama-French five-factor model from an investing perspective both in- and out-of-sample. Without margin requirements and model uncertainty, the Hou-Xue-Zhang model outperforms the Fama-French model. However, the outperformance could become negligible if an investor is subject to margin requirements and model uncertainty. The Hou-Xue-Zhang model shows similar power as the Fama-French model in describing the covariance matrix of asset returns. Overall, the two models do not make a difference for investing in a realistic setting.