Can the Whole Be More Than the Sum of the Parts? Bottom-Up Versus Top-Down MultiFactor Portfolio Construction
23 Pages Posted: 5 Dec 2017
Date Written: February 6, 2016
Rules-based factor portfolios combining multiple factors have become increasingly popular in recent years. One often-asked question concerning portfolio construction is whether combining individual factor portfolios is equivalent to building a bottom-up multi-factor portfolio. The latter has theoretical merit since each security’s weight in the portfolio will depend on how well it ranks on multiple factors simultaneously. The former approach may miss cross-sectional interaction effects between how factors express themselves at the security level. The authors analyze the magnitude of these effects here and find that these interaction effects can in fact have a significant impact on portfolio performance. Both intuition and empirical evidence favor bottom-up multi-factor portfolio construction.
Keywords: Factor Portfolios, Bottom-Up Construction, Blending Portfolios
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