Abstract
Although factor premiums originate in both long and short legs of factor portfolios, we found that (1) most added value comes from the long legs, (2) the long legs offer more diversification than the short legs, and (3) the performance of the short legs is generally subsumed by that of the long legs. These results are robust over size, time, and markets and cannot be attributed to differences in tail risk. We also found that the claim that the value and low-risk factors are subsumed by the new (post-2015) Fama–French factors does not hold for the long legs of these factors.
Highlights
David Blitz is managing director of Quantitative Investments at Robeco Asset Management, Rotterdam, the Netherlands
Factor portfolios are typically constructed by combining a long leg and a short leg under the assumption that the two legs are complementary drivers of factor premiums
We found that factor premiums originate in both legs but are typically stronger on the long side
Summary
When all five factors are combined (as in the last column), the long side—with a Sharpe ratio of 1.10 versus only 0.69 for the short side—clearly emerges as the winner This result indicates that the long legs diversify much better than the short legs. When three factors are combined, the Sharpe ratio goes up to 0.8, on average, for the long legs versus only 0.6 for the short legs. The correlation increases to 0.87 for the multifactor combination, which explains why, in Table 1, the volatilities of the long-leg portfolio (2.2%) and the short-leg portfolio (3.7%) almost fully add up to the volatility of the long–short portfolio (5.7%) These numbers show that the long legs and short legs offer closely related exposures, especially when factors are combined. Note: Shown are the Sharpe ratios of the average portfolio over all possible single-factor and multiple-factor portfolios for 1-2-3-4-5 factor combinations
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