Multifactor Portfolio Construction by Factor Risk Parity Strategies: An Empirical Comparison of Global Stock Markets

Since the financial crisis in 2008, factor investing has attracted the attention of investment managers and asset owners. A factor-based investment portfolio can enjoy effective diversification and acquire factor risk premiums at lower cost than active managers can. In equity investments, "smart beta" investing has been established as a common investment style and the multifactor strategy has become the most popular in recent years. This study makes an additional contribution to empirical research for risk-based asset allocation in multifactor investing. We verified the effectiveness of the factor risk parity (FRP) strategy by constructing active equity FRP portfolios for four stock markets, Japan, the United States, United Kingdom, and Euro countries. For the Japanese market, four factors considered to be effective in the market were adopted for constructing FRP portfolios. For the other markets, we constructed FRP portfolios by equalizing factor risk contributions between the cyclical and defensive factors. We found that the FRP strategy is a prospective method for capturing factor risk premiums, since it can adequately allocate risk to factors that contribute positive returns in the active FRP portfolios.