Strategic Implications for Portfolio Construction
One of the strategic implications of CAP-M is that the ultimate equity portfolio (measured in terms of maximum return per unit of risk) is the global portfolio. In other words, equity investors should strive to own their proportional share of all the world's traded stocks. Single factor models yield simple solutions.
Under the Three Factor Model, the result isn't quite so tidy. Investors must now decide how much of each of the three factors they are willing to hold when they construct their portfolios. They must manage the tradeoffs between the three factors to suite their own appetite for the various risks.
The good news here is that investors can now build portfolios with expected returns significantly higher than the global equity portfolio. By identifying the true priced sources of risk that generate returns, and managing their exposure to fundamental risk factors through passive structural portfolio engineering techniques they can obtain these additional benefits at dramatically lower costs.
These increased expected returns do not rely on any magic performance by an active manager. They can be economically achieved by building a portfolio of index funds that rely solely on exposure to risk factors that over time have demonstrated persistent strong positive premiums. This process takes a long step forward in turning investment management from voodoo science into a real discipline.