Factor Exposure Analysis 103

Long-short versus long-only factors

January 2025. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The belief in factor investing is based on research featuring long-short factors
  • However, almost all funds pursue long-only factor investing
  • Smart beta ETFs should be analyzed using long-only rather long-short factor indices

INTRODUCTION

Investors´ belief in factor investing is based on hundreds of academic research articles that demonstrate that factors like value or momentum can be used to outperform markets. Intuitively, investors should simply invest in products that are as close to the research as possible, however, in reality, they do not.

Take the value factor, which is defined as buying cheap and shorting expensive stocks. Close to 300 ETFs are trading in the U.S. capital markets that provide exposure to cheap stocks, but that is just one side of the factor. In contrast, there is not a single ETF that provides exposure to the long-short factor as seen in academic research (read Market-Neutral versus Smart Beta Factor Investing).

Naturally, this makes no sense but simply highlights that we are anything but rational investors (read Smart Beta vs Alpha + Beta). It also raises the question of what should be the independent variables when analyzing the returns of a factor-focused strategy.

In this research article, we will compare long-short and long-only factor indices for factor exposure analysis.

LONG-SHORT VERSUS LONG-ONLY FACTOR INDICES

Factor indices are created by selecting the top and bottom percentiles of stocks sorted on certain metrics, e.g. the price-to-book ratio is often used for the value factor, where the cheapest stocks represent the long and the most expensive stocks the short portfolio. If we only consider the cheapest stocks, then we derive a long-only portfolio that is typically marketed as a smart beta strategy. However, this portfolio´s risk will be dominated by the stock market rather than the factor.

We create long-short and long-only indices for the value, size, quality, momentum, and low volatility factors in the U.S