In new research just published in a special issue of the Journal of Portfolio Management on factor investing, ERI Scientific Beta has validated the superiority of the top-down approach to multi-factor investing over a bottom-up approach.
The ERI Scientific Beta paper, entitled "Accounting for Cross-Factor Interactions in Multifactor Portfolios without Sacrificing Diversification and Risk Control," compares different approaches for constructing multi-factor equity portfolios: "bottom-up" score-weighting approaches that target high factor intensity and "top-down" approaches that also consider diversification objectives.
The risks and shortcomings of the bottom-up approach are shown to be inefficiency, instability and the inability to control factor exposure and non-factor risks:
- Focusing solely on increasing factor intensity leads to inefficiency in capturing factor premia, as exposure to unrewarded risks more than offsets the benefits of increased factor scores.
- High factor scores in "bottom-up" approaches also come with high instability in factor exposure and high turnover.
- Concentrating portfolios in multi-factor champions can also lead to significant geographical or sector biases.
The authors introduce a new approach that considers cross-factor interactions in "top-down" portfolios through an adjustment at the stock selection level. This approach leads to higher levels of diversification and produces higher returns per unit of factor intensity. The authors report that it dominates "bottom-up" approaches in terms of relative performance, while considerably reducing extreme relative losses and turnover. In addition, this approach preserves the well-known benefits of the top-down approach in terms of explicit and transparent control of exposures to risk factors.
A copy of the article is accessible by clicking on the link below:
ERI Scientific Beta, 1 George Street, #07-02, Singapore 049145. For further information, please contact: contact@scientificbeta.com, Web: www.scientificbeta.com.
