This In Practice piece gives a practitioner’s perspective on the article “Fundamentals of Efficient Factor Investing” by Roger Clarke, Harindra de Silva, CFA, and Steven Thorley, CFA, published in the November/December 2016 issue of the Financial Analysts Journal.
What’s the Investment Issue?
The growth in factor-based equity portfolios is evidence that many investors now view managing factor exposures as being on par with traditional asset allocation. Investors typically focus on a handful of factors that are widely believed to outperform the market, such as low beta, small size, value, and momentum.
Investors tend not to allocate to these factors individually but, instead, combine them in multifactor portfolios. This begs the question of how best to combine factors to maximise performance. Currently, many investors build multifactor portfolios by allocating to packaged factor portfolios—for example, a small-size portfolio or a value portfolio—and then combining these packaged factor portfolios to create the desired exposures. The authors examine whether this approach leads to the best risk-adjusted returns or whether investing directly in individual stocks would improve performance.
How Do the Authors Tackle This Issue?
The authors go back to basic portfolio theory and apply to factor exposures the well-known mathematics used to create mean–variance portfolios. They show how pure factor portfolios can be created. Why? Because if investors can gain full exposure to a chosen factor and avoid any exposure to other factors, they can reap the full return potential of investing in that factor.
In practice, however, gaining pure factor exposures is very difficult. Pure factor portfolios require taking short positions in individual stocks, which is expensive to implement. In addition, many institutional investors have a long-only constraint that prohibits them from taking short positions.
The study, therefore, takes a practical approach and looks solely at long-only assets, using portfolio theory to predict the potential gain from investing in several factors in a single portfolio. By applying portfolio theory to factor investing, the authors are able to compare the performance of long-only multifactor portfolios constructed using individual securities against the performance of multifactor portfolios built by combining packaged factor portfolios.
The authors then backtest over a long period (1968–2015) the four most popular factors used by investors: low beta, small size, value, and momentum. Their aim is to discover to what extent combining individual securities, versus using packaged factor portfolios, can capture the potential return available through pure factor exposures.
What Are the Findings?
The central finding is that multifactor portfolios constructed using individual securities capture most of the gains available from pure factor portfolios, whereas combinations of packaged factor portfolios capture only a fraction of these gains. The increase in efficiency from using individual securities is due to the higher degree of accuracy that results from constructing portfolios with more precise factor exposures.
The loss of efficiency from allocating to packaged factor portfolios is substantial. To be precise, a multifactor portfolio combining packaged factor portfolios that includes low beta, small size, value, and momentum captures only about 40% of the potential improvement over the market’s Sharpe ratio; performance becomes progressively worse as investors add more factors to the portfolio. By contrast, a multifactor portfolio constructed directly from individual securities captures about 80% of the potential improvement over the market’s Sharpe ratio.
What Are the Implications for Investors and Investment Professionals?
Using this research, investment managers should be able to build multifactor portfolios that have a better risk–return profile than pre-packaged factor portfolios. The mathematics in the article show how to create weightings for individual securities to gain the desired exposures across a multifactor portfolio.
But the continued use of pre-packaged factor portfolios may still have benefits for some investment managers and their clients. First, building a multifactor portfolio from packaged factor portfolios is generally less complex than using individual securities and is, therefore, more easily understood by investors.
Second, the use of pre-packaged factor portfolios allows investors to select the most relevant factors for their needs and to rapidly and cheaply either add new factors to or divest existing factors from their portfolio should their views change.
Third, the performance of separate factor portfolios is simpler to track, which facilitates performance attribution.
However, as this research suggests, such simplicity comes at a high cost.