Intersectional Model: Sorting 7 Factors

Searching for Jack of All Trades on the Stock Market

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

SUMMARY

  • Focusing purely on Value is a difficult strategy
  • Sorting by multiple factors improves performance and risk-metrics
  • However, factor selection and allocation remain challenging topics

INTRODUCTION

Value is likely the most common strategy for equity fund managers as the principle of buying something at a discount is intuitively appealing to human nature. However, pursuing a pure Value strategy is challenging as the stocks in the portfolio are by nature unpleasant to hold. These tend to be companies that lack a sound corporate strategy, have declining sales and earnings, feature incompetent management, are too highly indebted, or have some other reason that explains why the stocks are trading cheaply. Given that holding pure Value stocks is emotionally difficult, most fund managers add other factors in order to make the portfolio more palatable. In this short research note we will analyse the effect of adding six further factors to a Value portfolio, thus making it a multi-factor portfolio.

METHODOLOGY

There are three types of multi-factor models:

  • Combination model: Single factor portfolios are created and combined into one portfolio
  • Intersectional model: Stocks are ranked by several factors simultaneously
  • Sequential model: Stocks are sorted by factors sequentially

In this research report we will use the intersectional model by sorting stocks for several factors simultaneously, i.e. looking for the stocks in the intersection of the variables. We focus on seven factors namely Value, Size, Momentum, Low Volatility, Quality, Growth and Dividend Yield. The factors are created by constructing long-short beta-neutral portfolios of the top and bottom 10% of stocks of the US stock market. Portfolios rebalance monthly, allocate equally between factors and include 10bps of transaction costs.

VALUE VS VALUE & SIZE

There is a large amount of research on the Value and Size factors given that these are part of the three-factor Fama-French model that created the foundation of factor investing. Although the Size factor has not generated attractive returns after it was identified by Banz in 1981, there is empirical evidence that the Value strategy performs stronger in the small and mid capit