Inside the Black Box: The Simple Truth About Quantitative Trading

6.1. RULE-BASED PORTFOLIO CONSTRUCTION MODELS

There are four types of rule-based portfolio construction models: equal position weighting, equal risk weighting, alpha-driven weighting, and decision-tree weighting. The first two are the simplest and have at their core a philosophy of equal weighting; they differ only in what specifically is being equally weighted. Alpha-driven portfolio construction models mainly rely on the alpha model for guidance on the correct position sizing and portfolio construction. Decision-tree approaches, which look at a defined set of rules in a particular order to determine position sizing, can be rather simple or amazingly complex. I describe these approaches from simplest to most complex.

6.1.1. Equal Position Weighting

Equal position-weighted models are surprisingly common. These models are used by those who implicitly (or explicitly) believe that if a position looks good enough to own, no other information is needed (or even helpful) in determining its size. The notion of the strength of a signal, which, as already discussed, is related to the size of a forecast for a given instrument, is ignored except insofar as the signal is strong enough to be worthy of a position at all. At first glance, this might seem like an oversimplification of the problem. However, some serious quants have arrived at this conclusion. The basic premise behind an equal-weighting model is that any attempt to differentiate one position from another has two potentially adverse ...