Factor-Based Optimization of a Fundamentally-Weighted Portfolio in the Illiquid and Undeveloped Stock Market

Abstract

In this paper, the possibility of using fundamental weighting as a tool to intentionally tilt a portfolio toward specific and unobservable risk factors in the illiquid and undeveloped Croatian stock market is explored. Thus far, fundamental-weighting has been shown to be able to outperform the cap-weighted index in such environments but no attempt regarding control for implicit factor exposure of such portfolios has been reported. Therefore, in this study principal component analysis is performed to capture the underlying risk factors of the fundamentally-weighted portfolio in order to optimize the portfolio’s performance by minimizing its volatility. Previous attempts focusing purely on portfolio risk reduction by estimating minimum variance portfolios failed both from an in-sample and out-of-sample perspective. Results in this study are based on 22 in-sample and out-of-sample tests in the period from March 2009 till March 2020. On the in-sample estimation basis, the proposed approach significantly improves the portfolio’s performance and, if restrictions to weights are imposed, it can outperform the cap-weighted benchmark. However, out-of-sample testing yielded poor results both in terms of risk and return. Such results are in contrast to findings for the developed markets but corroborate the claim that a broad investment base is needed for successful risk exposure in the long run.