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Why you should care about factors

While it’s no secret that factor investing continues to grow, some market participants still have questions. Some are interested in learning how to best incorporate factors into their overall portfolio construction, but others are more fundamentally vexed as to why they should care about factors at all. Our most recent paper, “Factor Indexes and Factor Exposure Matching: A Like-for-Like Comparison,” clearly demonstrates that these seemingly abstract quantities do, in fact, drive the performance of suitably diversified portfolios. That is, diversified portfolios with identical factor exposures—but with very different constituents and weights—have similar performance outcomes. If this were not the case the factor story would fall down.

In our paper, we compare single factor selection and weighting, or S&W—which is a common portfolio construction technique—to multiple tilt portfolios whose tilts are chosen to precisely match the S&W portfolio’s five factor exposures. It turns out that performances are more or less the same, but the diversification and implementation properties favor the bottom-up tilting approach. Never mind that the S&W portfolio is less efficient. It is in an inherently multi-factor portfolio where the target factor plays a potentially minor role. The top-down construction of multi-factor portfolios using S&W portfolios then becomes somewhat opaque since each sleeve is essentially itself a multi-factor portfolio.

Our paper makes the strong case that it is more logical and consistent to create controlled multi-factor portfolios using a bottom-up approach from the start, and then demonstrates that the exposure matching concept generalizes to more complicated smart beta portfolios that are not necessarily designed to target factors. To see for yourself, watch a brief video summary of the new paper featuring FTSE Russell’s Andy Dougan, director, research and analytics, then read the paper to decide for yourself.

 

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