Equity Multi-Factor Approaches: Sum of Factors vs. Multi-Factor Ranking
Barclays Investment Strategies (QIS) Group (2016)
21 Pages Posted: 5 Nov 2018 Last revised: 26 Dec 2019
Date Written: September 16, 2016
There is a plethora of literature on the persistence and rationale of individual equity factor premia, which investors are often advised to extract through forming multi-factor portfolios – however, not so much attention is paid to the nuances of forming such portfolios and their implications.
There are generally two approaches for forming equity multi-factor portfolios:
- Sum of Factors (SoF) – where separate respective factor portfolios are first formed which are then subsequently combined.
- Multi-Factor Ranking (MFR) – where individual stocks are selected based on a specified multi-factor ranking model.
In this paper, we empirically demonstrate the implications of the two approaches when allocating across four equity factors: Value, Momentum, Low Volatility and Quality. We do so in the context of two topical implementation considerations:
- Portfolio size: Concentrated versus diversified portfolios.
- Factor exposure: Ex-ante versus ex-post factor exposure.
In summary when comparing the two approaches, we find:
- MFR portfolios have historically outperformed SoF portfolios irrespective of portfolio size.
- However, this has been historically driven by the persistently lower CAPM Beta of the MFR portfolios, which has not been by design and which is accentuated in concentrated portfolios.
- This lower CAPM Beta is from an implicit low volatility factor bias.
- Such a bias comes with performance risk implications that investors should be mindful of.
Keywords: smart beta; factors; portfolio construction
JEL Classification: G10; G11
Suggested Citation: Suggested Citation