Is sector-neutrality in factor investing a mistake?

Abstract

Stock characteristics have two sources of predictive power. First, a characteristic might be valuable in identifying high or low expected returns across industries. Second, a characteristic might be useful in identifying individual stock expected returns within an industry. Past studies generally find that the firm-specific component is the strongest predictor, leading many to sector neutralize their factor exposures. We show that this problem is equivalent to the classic two risky-asset problem and derive the condition that decides when the sector component of a characteristic should be omitted. We show both analytically and empirically that the long–short investor is more likely to benefit from hedging out sector bets, whereas the long-only investor is more likely to benefit from investing in the factor as it stands.