Factor Construction: Portfolio Scenarios

How Many Stocks Are Needed to Capture Factor Returns?

November 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Most researchers create factor portfolios by taking the top & bottom 30% of stocks, which results in large portfolios
  • Portfolios can be reduced, but firm risks start influencing factor returns with too few stocks
  • Most investors are likely better of buying factor products then building factor portfolios themselves

INTRODUCTION

Investors glancing at the Wilshire 5000 Total Market Index would intuitively assume that the index contains 5,000 stocks, unless they already know that it currently only contains about 3,800 stocks. Interestingly the index included 7,500 stocks in 1998. The significant decline in stocks can mainly be attributed to M&A activities, private equity take-privates and fewer IPOs. The universe shrinks further to about 1,600 stocks when a few simple filters like minimum market capitalisations of $1 billion or minimum volumes are considered. However, 1,600 stocks is still a large universe for factor investors, considering that most academic researchers create factor portfolios by taking the top and bottom 30% of the stock universe. In this short research note we will analyse how many stocks investors require to effectively create factor portfolios (read Smart Beta vs Factors in Portfolio Construction).

METHODOLOGY

We utilise two sets of factor data for the US stock market. The first is from Fama-French, which includes Value, Size and Momentum, and the second is our data, which includes the first three factors as well as Low Volatility, Quality, Growth and Dividend Yield. The factors are created by constructing long-short beta-neutral portfolios of the top and bottom stocks of the US stock market. Portfolios are rebalanced monthly and include 10bps of transaction costs.

FACTOR PORTFOLIO CONSTRUCTION CONSIDERATIONS

Most academic research on factor investing is based on long-short portfolios that take the top and bottom 30% of the stock market. For our definition of tradable stocks in the US, which results in approximately 1,600 stocks, this implies 480 stocks on the long and 480 stocks on the short side, which is not practical for most investors. Only if we reduce the