Factor Portfolios and Efficient Factor Investing

Abstract

Combining long-only-constrained factor sub-portfolios is generally not a mean-variance-efficient way to capture expected factor returns. For example, a combination of four fully invested factor sub-portfolios — low beta, small size, value, and momentum — captures less than half (e.g., 40%) of the potential improvement over the market portfolio’s Sharpe ratio. In contrast, a long-only portfolio of individual securities, using the same risk model and return forecasts, captures most (e.g., 80%) of the potential improvement. We adapt traditional portfolio theory to more recently popularized factor-based investing and simulate optimal combinations of factor and security portfolios, using the largest 1,000 common stocks in the US equity market from 1968 to 2015.