Factor Construction Zoo: Are Factor Exposures Created Equal?

Abstract

The answer is no. Investors hunt factor exposures and premium across the stock universe. However, the relation between factor exposures and returns is non-linear. Large-scale simulation shows that similar target factor exposures can be engineered using various portfolio construction methodologies, but the resulting portfolios exhibit significant dispersion in expected returns and comovement with the market and other factor funds. The dispersion increases with target factor exposures. As such, some factor exposures are more efficient than others. This paper further studies a comprehensive list of portfolio construction choices for value, momentum, and quality funds, discusses the tradeoff at work, and provides a framework for the assessment of factor exposure efficiency. It is important to account for non-linearity in constructing or evaluating factor funds.

Keywords: factor exposure, portfolio construction, risk, return, non-linearity

JEL Classification: G10, G11, G12