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Strategic allocation to premiums in the equity market

Abstract

01-07-2011 | Research | David Blitz, PhD

Investors tend to focus on harvesting the risk premiums offered by traditional asset classes when making their strategic investment decisions. Some recent papers, however, argue that investors should also consider various other premiums, that are known to exist in financial markets, for possible inclusion in the strategic asset allocation. Examples of such premiums that have been documented for the equity market are the size, value, momentum and low-volatility effects.

In this note we show that the theoretically optimal strategic allocation to such premiums is sizable, even when using highly conservative ssumptions regarding their future expected magnitude. We also discuss the pros and cons of two ways of obtaining exposure to these premiums in practice, specifically passively managed ‘smart beta’ funds versus actively managed quant funds.

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