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Bridge over ocean
1 November 2016 Financial Analysts Journal Volume 72, Issue 6

Fundamentals of Efficient Factor Investing (corrected May 2017)

  1. Roger G. Clarke
  2. Harindra de Silva, CFA
  3. Steven R. Thorley, PhD, CFA

Combining long-only-constrained factor subportfolios is generally not a mean–variance-efficient way to capture expected factor returns. For example, a combination of four fully invested factor subportfolios — low beta, small size, value, and momentum — captures less than half (e.g., 40%) of the potential improvement over the market portfolio’s Sharpe ratio. In contrast, a long-only portfolio of individual securities, using the same risk model and return forecasts, captures most (e.g., 80%) of the potential improvement. We adapt traditional portfolio theory to more recently popularized factor-based investing and simulate optimal combinations of factor and security portfolios, using the largest 1,000 common stocks in the US equity market from 1968 to 2015.

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