Is Sector-neutrality in Factor Investing a Mistake?

31 Pages Posted: 10 Nov 2021 Last revised: 24 Jan 2022

See all articles by Sina Ehsani

Sina Ehsani

Northern Illinois University

Campbell R. Harvey

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)

Feifei Li

Research Affiliates, LLC

Date Written: December 22, 2021

Abstract

Stock characteristics have two sources of predictive power. First, a characteristic might be valuable in identifying high or low expected returns across industries. Second, a characteristic might be useful in identifying individual stock expected returns within an industry. Past studies generally find that the firm-specific component is the strongest predictor, leading many to sector neutralize their factor exposures. We show that this problem is equivalent to the classic two risky-asset problem and derive the condition that determines when the sector component of a characteristic should be omitted. We show both analytically and empirically that the long–short investor is more likely to benefit from hedging out sector bets, whereas the long-only investor is more likely to benefit from investing in the factor as it stands.

Keywords: Sector neutralization, industry factors, equity factors, sector neutral, sector bet, sector tilt, factor zoo, portfolio management, smart beta

JEL Classification: G11, G12, G15, M41

Suggested Citation

Ehsani, Sina and Harvey, Campbell R. and Li, Feifei, Is Sector-neutrality in Factor Investing a Mistake? (December 22, 2021). Available at SSRN: https://ssrn.com/abstract=3959116 or http://dx.doi.org/10.2139/ssrn.3959116

Sina Ehsani

Northern Illinois University ( email )

Chicago, IL 60115
United States

Campbell R. Harvey (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7768 (Phone)

HOME PAGE: http://www.duke.edu/~charvey

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Feifei Li

Research Affiliates, LLC ( email )

620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8753 (Phone)
949-325-8953 (Fax)

HOME PAGE: http://researchaffiliates.com/index.htm

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