Practical Applications of Accounting for Cross-Factor Interactions in Multi-Factor Portfolios without Sacrificing Diversification and Risk Control

Abstract

Practical Applications Summary Increasing investor interest in multi-factor solutions has product providers debating the respective merits of the “top-down” and “bottom-up” approaches to multi-factor portfolio construction. In Accounting for Cross-Factor Interactions in Multi-Factor Portfolios without Sacrificing Diversification and Risk Control, published in the 2017 Special Issue of The Journal of Portfolio Management, Noel Amenc, Frederic Ducoulombier, Mikheil Esakia, Felix Goltz, and Sivagaminathan Sivasubramanian at ERI Scientific Beta compare the two strategies. They find that focusing on increasing composite factor scores through score-based weighting leads to inefficiency in capturing factor premia. High factor scores in score-weighted bottom-up approaches also come with high instability and turnover. The team introduces a hybrid approach that considers cross-factor interactions in top-down portfolios through an adjustment at the stock-selection level. The approach produces significantly higher factor intensity and improves absolute performance and risk-adjusted performance relative to the traditional approach while keeping turnover in check.