How do I set a factor risk budget across value, momentum, quality, and low-vol?

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AcadiFi · Accepted Answer

Factor risk budgeting allocates active risk (TE vs. benchmark) across style factors, similar to asset-class budgeting. Typically equal-risk-weighted across factors unless conviction dictates otherwise.

Standard approach: target TE = 4%, split across 4 factors equally → each factor should contribute 1% TE in quadrature, meaning 2% stand-alone TE per factor (since 4 × 1² = 4 = 2²).

Example: Calverton Quant Advisors manages a $500M multi-factor equity portfolio vs. Russell 1000.

Budget: 4% total TE, 4 factors = value, momentum, quality, low-vol.

Equal risk: each factor targets 2% stand-alone TE, contributing 1% to portfolio TE assuming independence.

Factor correlations matter: empirically value and momentum are weakly negatively correlated (-0.2), quality and low-vol positively correlated (0.4). Adjusted contributions:
- Value: 0.95% contribution
- Momentum: 0.98% (benefits from diversification with value)
- Quality: 1.18% (clustered with low-vol)
- Low-vol: 1.15%

Sum (in quadrature with correlation): 4.05% TE — slightly over budget. Calverton reduces quality factor from 2.0% to 1.75% stand-alone to hit 4% exactly.

Alternative: risk parity across factors weighted by Sharpe. If momentum has historical Sharpe 0.65 vs. value 0.35, allocate more risk to momentum. Requires expected return estimates.

Rebalancing: factor correlations change (2018 shocked value-momentum correlation to +0.3), so Calverton re-estimates quarterly using 3-year rolling window and re-balances factor weights to hit target. CFA curriculum emphasizes governance: risk budget policy should be documented, approved by risk committee, and reviewed annually.

How do I set a factor risk budget across value, momentum, quality, and low-vol?

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