Multi-Factor Portfolio Construction for Passively Managed Factor Portfolios

Abstract

Transparent rules-based index-tracking portfolios that employ alternative weighting schemes have grown rapidly in the last decade, especially within equities. These passively managed factor portfolios can be constructed in many ways, ranging from relatively simple rules-based approaches that specify weights as a function of factor characteristics to more complex optimization-based ways. Both single factor and multiple factor portfolios can be constructed. In the latter case, one often-asked question is whether it is better to combine individual factor portfolios or build a multi-factor portfolio from the security-level. Here, we show that a bottom-up approach to multi-factor portfolio construction can produce superior results than a combination of individual single factor portfolios, at least for well-known factors such as Value, Quality, Low Volatility, and Momentum. Because the bottom-up approach assigns weights to securities on multiple factor dimensions simultaneously, it accounts for cross-sectional interaction effects in a way that combining single factor portfolios does not.