Factor Optimization

Pure versus Dirty Factors

December 2018. Reading Time: 15 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Equity factors exhibit sector biases and exposures to other common factors
  • A factor optimisation process allows investors to create pure factors
  • Risk-adjusted returns do not increase, but pure factors are attractive from analytical, risk and allocation perspectives

INTRODUCTION

When large quantities of organisms like zooplankton and algae are buried underneath sedimentary rock and subjected to intense heat and pressure, petroleum is created. It is a substance that is usually brown or black and contains a mixture of gas, liquids and solid hydrocarbons.

The Chinese were the first to start refining petroleum into fuel about 2,000 years ago. Being able to refine petroleum into oil and gasoline has been instrumental in accelerating the growth of human civilization as these have become primary energy sources.

In factor investing, single factor portfolios can be considered the equivalent of petroleum as they are essentially unrefined. Creating a Value factor portfolio consists of ranking stocks on single or multiple valuation metrics like price-to-book or price-to-earnings multiples. However, the resulting portfolio will by nature feature biases to certain sectors and exposure to other common equity factors.

In this white paper, we will introduce a factor optimization process that maximises the exposure to a target factor and minimises the exposure to non-target factors. We will initially focus on the Value factor in the US, then expand to other common equity factors in the US, and finally conclude with multi-factor portfolios across markets (read Stock Portfolio Optimization).

METHODOLOGY

We focus on five factors namely Value, Size, Momentum, Low Volatility, and Quality in the US, European, and Japanese stock markets. The factor definitions are in line with industry standards and the factor performance is calculated by constructing beta-neutral long-short portfolios by taking the top and bottom 10% of the stock universe ranked by the factor. Only stocks with market capitalisations of larger than $1 billion are considered. Portfolios are rebalanced monthly and 10 basis points of costs per transaction are included. The analysis cover