Scientific Beta

IPE: "Noël Amenc, Frédéric Ducoulombier, Felix Goltz and Sivagaminathan Sivasubramanian look at the pros and cons of top-down and bottom-up strategies for factor investing."

IPE May 2017

Top-down versus bottom-up multi-factor approaches
Article by Noël Amenc, Frédéric Ducoulombier, Felix Goltz and Sivagaminathan Sivasubramanian
"(...) At a glance: Academic studies have paid relatively little attention to the variability of these factor premia over time and to the short and medium-term risks of investment along factor lines. Critics of the traditional top-down approach observe that there is a downside to assembling indices that have been designed to independently target distinct factors. The most flexible way to produce portfolios that score highly across the characteristics that proxy for exposure to a set of targeted factors is to build multi-factor portfolios from the bottom-up. Modifying smart-factor index selections to take cross-factor exposures into consideration allows exposures to be improved while preserving the transparency, flexibility and efficiency of the top-down approach. (...)"
The great factor debate
"(...) Noël Amenc, professor of finance at the EDHEC-Risk Institute in Nice, is closer to Ang’s view. “I am more favourable towards rational explanations,” he says. “Smart beta [an alternative term for factor investing] works because you have serious sources of return, well-documented by academia. The first one is obviously the exposure to rewarded factors. These are backed by Nobel prize-winning work. Such returns from factors are not an anomaly. They are really a reward for taking long-term risks.” That does not mean that Amenc rules out behavioural explanations entirely. On the contrary, EDHEC has produced a useful summary of the main explanations, rational and behavioural for some of the best-known factors (see Economic mechanisms behind main factors). (...)"
Getting the blend right
"(...) Not all industry practitioners accept that bottom-up factor combination approaches are superior to those constructed from the top down. “When you select so-called factor ‘champions’ in a bottom-up approach, you create a concentrated portfolio with high turnover,” says EDHEC’s Felix Goltz. “But there’s a more conceptual problem as well. The academic studies on which factor investing relies all used a top-down approach. Fama and French looked at the value and size effects across the whole stock market, for example. “The factor relationships that were originally defined using a top-down approach may break down if we start to make too precise distinctions about factor scores at the individual stock level,” Goltz continues. “The problem about bottom-up approaches is that you may end up overexploiting the information you have in stock-level factor scores. It’s better to stick to a broad-brush approach.” (...)"
Meeting expectations
"(...) It is important to have realistic expectations about what factor investment can deliver. Its supporters make a strong case for its advantages but even they concede it is far from a panacea. (...) According to Professor Noël Amenc, a professor of finance at EDHEC Business School in Nice, the academic literature suggests that improved performance of 2-3% a year on average is feasible. That may not sound like a lot to some but compounded over several years it would make a considerable difference. (...)"
Case Studies: LPP and FRR
"(...) Rather than just using alternative indices tactically, FFR started to consider using these indices for a more strategic asset allocation. Rousseau says: “We recognised that we could collect the risk premia associated with different investment factors over a full market cycle with better risk metrics.” To implement this approach, the fund allocated funds to four different indices – a low-volatility index, an EDHEC risk-efficient index as well as a risk parity index (...). Rousseau says: “We liked the maximum diversification of the EDHEC index and the new generation of risk parity indices.” (...)"