Fundamentals of Efficient Factor Investing
Financial Analysts Journal, Vol. 72, No. 6 (November/December 2016)
Posted: 10 Jun 2015 Last revised: 12 Oct 2016
Date Written: October 11, 2016
Combining long-only-constrained factor sub-portfolios is generally not a mean-variance-efficient way to capture expected factor returns. For example, a combination of four fully invested factor sub-portfolios — 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.
Keywords: Portfolio Theory, Factor Portfolios, Factor Investing, Portfolio Constraints, Smart Beta
JEL Classification: G11
Suggested Citation: Suggested Citation