Scientific Beta

Funds Europe: "Many investors are seeking to improve the performance of their equity portfolios by capturing exposure to rewarded factors. In this article, we analyse the potential benefit of combining factor tilts. Combinations of tilts to different factors may be of interest for two reasons."

Funds Europe 17/09/2014

"(…) Felix Goltz and Antoine Thabault assess the performance and implementation benefits of multi-factor allocations. (...) Many investors are seeking to improve the performance of their equity portfolios by capturing exposure to rewarded factors. In this article, we analyse the potential benefit of combining factor tilts. Combinations of tilts to different factors may be of interest for two reasons. First, multi-factor allocations are expected to result in improved risk-adjusted performance. In fact, even if the factors to which the factor indices are exposed are all positively rewarded over the long term, there is extensive evidence that they may each encounter prolonged periods of underperformance. More generally, the reward for exposure to these factors has been shown to vary over time. If this time variation in returns is not completely in sync for different factors, allocating across factors allows investors to diversify the sources of their outperformance and smooth their performance across market conditions. Intuitively, we would expect pronounced allocation benefits across factors which have low correlation with each other. Our research has shown that the correlation of the relative returns of four smart factor indices (low volatility, mid-cap, value and momentum) over the cap-weighted benchmark is well below one. This entails in particular that a combination of these indices would lower the overall tracking error of the portfolio significantly. The same analysis done conditionally for either bull or bear market regimes leads to similar results. (...)"