Tilt Nickels To Diamonds: An Orthogonalization Approach

Vol. 17, No. 4, 2019

Alternative index products often achieve improved performance at the cost of increased exposure to risk. In this study, we propose a portfolio tilting strategy that alleviates the risks inherent to alternative indices by projecting fundamental factors on risk factors to purge the influence of risk factors. We argue that more efficient indices can be built on the resulting orthogonalized fundamental factors and show that a tilted equity index using return on assets, long-term-debt, and net sales as fundamental factors outperforms the Russell 1000 index by 120 basis points from 1987 to 2014.