Abstract
Despite extensive research support, the role of diversification in current factor investing strategies remains neglected. This paper investigates whether well-designed multifactor portfolios should not only be based on firm characteristics, but should also include portfolio diversification effects. While the alpha concentration approach mainly considers factor-specific firm characteristics, the diversified approach utilizes covariance estimators in addition to firm characteristics to account for portfolio diversification. The corresponding out-of-sample results show that including an efficient covariance estimator improves the performance of long-only multifactor portfolios compared to the pure alpha concentration approach. A particular advantage of diversified factor investing strategies can be identified in the significant increase in exposure to the low-volatility factor represented by firm characteristics with high informational content. No significant performance differences are observed for long-short portfolios where the factor exposures of the alpha concentration and diversification approaches are similar with respect to the low-volatility factor.
Highlights
Factor investing, labeled smart beta, has recently become a well-known alternative to market capitalized index investing
Higher exposures in firm characteristics with high informational content lead to a higher ability to generate alpha
This article contributes to the current literature on the advantages of diversified versus concentrated multifactor portfolios
Summary
Factor exposures are determined by the weighted z scores where the portfolio weights are applied. Averages are calculated from the time series of the cross-sectional results evident that the low-volatility factor exposure of the diversification approaches in the LO portfolios is on average almost twice as high as in the Alpha-Con portfolios. This outcome can be explained by the fact that the low-volatility stocks in the LO portfolios are weighted higher by taking covariances into account. The LO portfolios benefit from the diversification approach because the additional low-volatility exposure contributes significantly to higher alpha performance results. The LS diversified portfolios are not able to increase the low-volatility exposure relative to the AlphaCon approach, and the performance results are not significantly different.
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