Are Factor Portfolios Better Diversified Than Not?

Are Factor Portfolios Better Diversified Than Not?

by Corey Hoffstein, Newfound Research

This post is available as a PDF here.

  • The debate rages on over the application of valuation in factor-timing methods. Regardless, diversification remains a prudent recommendation.
  • How to diversify multi-factor portfolios, however, remains up for debate.
  • The ActiveBeta team at Goldman Sachs finds new evidence that composite diversification approaches can offer a higher information ratio than integrated approaches due to interaction effects at low-to-moderate factor concentration levels.
  • At high levels, they find that integrated approaches have higher information ratios due to high levels of idiosyncratic risks in composite approaches.
  • We return to old research and explore empirical evidence in FTSE Russell’s tilt-tilt approach to building an integrated multi-factor portfolio to determine if this multi-factor approach does deliver greater factor efficiency than a comparable composite approach.

The debate over factor timing between Cliff Asness and Rob Arnott rages on.  This week saw Cliff publish a blog post titled Factor Timing is Hard providing an overview of his recently co-authored work Contrarian Factor Timing is Deceptively Difficult.  Generally in academic research, you find a certain level of hedged decorum: authors rarely insult the quality of work, they just simply refute it with their own evidence.

This time, Cliff pulled no punches.

In multiple online white papers, Arnott and co-authors present evidence in support of contrarian factor timing based on a plethora of mostly inapplicable, exaggerated, and poorly designed tests that also flout research norms.

At the risk of degrading this weekly research commentary into a gossip column: Ouch.  Burn.

We’ll be providing a much deeper dive into this continued factor-timing debate (as well as our own thoughts) in next week’s commentary.

In the meantime, at least there is one thing we can all agree on – including Cliff and Rob – factor portfolios are better diversified than not.

Except, as an industry, we cannot even agree how to diversify them.

Diversifying Multi-Factor Portfolios: Composite vs. Integrated

When it comes to building multi-factor portfolios, there are two camps of thought.

The first camp believes in a two-step approach.  First, portfolios are built for each factor.  To do this, securities are often given a score for each factor, and when a factor sleeve is built, securities with higher scores receive an overweight position while those with lower scores receive an underweight.  After those portfolios are built, they are blended together to create a combined portfolio.  As an example, a value / momentum multi-factor portfolio would be built by first constructing value and momentum portfolios, and then blending these two portfolios together.  This approach is known as “mixed,” “composite,” or “portfolio blend.”

Source: Ghayur, Heaney, and Platt (2016)

The second camp uses a single-step approach.  Securities are still given a score for each factor, but those scores are blended into a single aggregate value representing the overall strength of that security.  A single portfolio is then built, guided by this blended value, overweighting securities with higher scores and underweighting securities with lower scores.  This approach is known as “integrated” or “signal blend.”

Source: Ghayur, Heaney, and Platt (2016)

To re-hash the general debate: