Skip to content
Empirical Asset Pricing and Factor Investing / Constructing factor portfolios

Neutralisation

A book-to-price sort that is long utilities and short technology has not isolated cheapness. It has taken a sector bet that happens to line up with valuation. Neutralisation is the step that removes exposures the researcher did not claim to forecast — sector, beta, size — before the portfolio's return is read as evidence for the characteristic. The constraint set in the optimiser already solves the quadratic programme. This note chooses which exposures are zeroed, and it shows what that choice does to the information coefficient of book-to-price.
Learning objectives. By the end of this note you should be able to:
  • separate a within-sector percentile rank from a hard zero-exposure constraint;
  • build a beta-neutral book as a combination of characteristic portfolios, and state why dollar neutrality is a different constraint;
  • compare raw and risk-adjusted information coefficients on the same book-to-price row;
  • say what the −0.08-0.08 correlation between the size and book-to-market mimicking portfolios is checking.

In this lesson

  1. Rank inside the peer group, or constrain the book
  2. Beta neutrality is a second characteristic portfolio
  3. What zeroing does to the book-to-price number

Before you start

The full lesson, with worked examples and exercise solutions, is for members.

Read the full lesson

New to SelfMadeQuant.com? See membership options or browse the Empirical Asset Pricing and Factor Investing syllabus.