Penalizing variances for higher dependency on factors

Quantitative Finance, March 2017

Constructing equity portfolios to control for stock market volatility and unforeseen portfolio losses is critical for meeting investment objectives.Mean-variance analysis (Markowitz, 1952, 1959) was the earliest documented quantitative approach to portfolio selection where the mean and variance of portfolio returns are considered for constructed optimal portfolios. The mean-variance model sparked much research on portfolio optimization, especially models incorporating shortcomings of mean-variance analysis (Fabozzi et al. 2002, Kolm et al. 2014), and the mean-variance framework also has been applied to numerous area such as manufacturing and electricity markets (see, for example, Gosavi 2006, Roques et al. 2008, Chiu and Choi 2016).