Keep the Alpha, Cut the Risk: Macro-Factor and PC Neutralization in Equity Portfolios

This is the sixtieth edition of our Quantcraft series, evaluating the benefits and shortcomings of tight risk neutralisation in equity factor portfolios. We proxy additional risk factors through both (i) principal components and (ii) our macro risk model, and show the trade-off between higher risk-adjusted returns and higher costs. Our use of the risk factors differs from academic literature and commercial vendors as we use the stock-specific betas to the risk factors as constraints in the optimisation, not to compute the covariance. We apply the framework to our dynamic equity long-short multifactor strategy, N-LASR. The higher risk-adjusted returns – close to 30% in backtested Sharpe ratios – stem from the reduction in volatility of the neutralised portfolios, while higher turnover boosts costs, mainly because of the additional leverage required to match ex-ante volatility of the benchmark. Return improvements are concentrated on tail events, typically linked to Momentum crashes and