Factor Investing: Risk Premia vs. Diversification Benefits
43 Pages Posted: 8 Jun 2015 Last revised: 10 Sep 2017
Date Written: August 1, 2017
Factor investing emerged as the byproduct of factor models of asset pricing. It consists in holding assets with positive exposure to selected risk factors and, if possible, shorting those with negative exposure. This paper assesses the merits of factor investing on the U.S. stock market by using sector investing as the benchmark. Our results reveal a trade-off between the risk premia associated with factors and the diversification potential of sectors. When short selling is authorized, factor investing outperforms sector investing in all respects. For long-only portfolios, factor investing tends to be more profitable than the benchmark during expansion times and bull periods, but less attractive during recessions and bear periods, i.e., in periods where diversification is needed the most.
Keywords: Investment, asset allocation, factor, industry, sector, crisis
JEL Classification: G11, G01, C58, D92
Suggested Citation: Suggested Citation