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15 May 2023 Financial Analysts Journal Volume 79, Issue 3

Is Sector Neutrality in Factor Investing a Mistake?

  1. Campbell R. Harvey
  2. Feifei Li
  3. Sina Ehsani
Because research shows that the strongest predictor for stocks is the firm-specific component, many investors sector-neutralize their factor exposures. This study develops a framework to determine when the sector component should be neutralized.
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Stock characteristics have two sources of predictive power. First, a characteristic might be valuable in identifying high or low expected returns across industries. Second, a characteristic might be useful in identifying individual stock expected returns within an industry. Past studies generally find that the firm-specific component is the strongest predictor, leading many to sector neutralize their factor exposures. We show both analytically and empirically that the average long–short investor is more likely to benefit from hedging out sector bets, whereas the long-only investor should, on average, avoid sector neutralization.

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