Implementation Matters: Relaxing Constraints Can Improve the Potential Returns of Factor Strategies

Abstract

Eligible investors seeking factor exposures may have a choice of different investment vehicles to implement an investment strategy, ranging from fully transparent, index-based exchange-traded funds to private funds or undertakings for collective investment in transferable securities. In this article, the authors assess the impact of constraints common to these investment vehicles through the lens of hypothetical equity momentum and value factor strategies. As constraints—leverage, trading frequency, and risk levels—on the factor strategies are relaxed, risk-adjusted potential returns may improve. Conversely, moving from an unconstrained implementation to a low-turnover, long-only implementation may decrease the Sharpe ratios of momentum and value strategies by as much as 60%.