Minimum Correlation Factor Portfolios

The lower the factor correlation, the better?

December 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Minimizing factor correlations is a common approach to creating multi-factor portfolios
  • However, the diversification benefits from minimizing the correlations of long-only two-factor portfolios were marginal
  • This suggests that investors should not focus too much on correlations when combining smart beta strategies

INTRODUCTION

The two basic of rules of asset allocation are: i) identify assets with positive expected payoffs, and ii) ensure that the assets are not too highly correlated, so that diversification benefits can be harvested. Although the rules are simple, implementation is often complex.

Equities have a positive expected return over the long-term as stocks represent risk capital in for-profit companies. Bonds pay interest. However, the case is not so clear for some asset classes like commodities or currencies. Neither Gold nor Bitcoin generate cashflows and are mainly driven by market sentiment.

Similarly, when creating a multi-factor portfolio, an investor should select factors that are expected to generate positive excess returns and are not too highly correlated. A classic strategy would be to combine Value and Momentum, where research shows that these allow investors to outperform markets while being lowly correlated to each other as cheap stocks are typically not outperforming and the best-performing stocks tend to trade at expensive valuations.

In this short research note, we will analyze two-factor portfolios created by minimizing factor correlations.

METHODOLOGY

We focus on seven factors namely Value, Size, Momentum, Low Volatility, Quality, Growth, and Dividend Yield in the US stock market. The long-only portfolios are created by selecting the top 30% stocks ranked by the factor definitions, which are in line with industry and academic standards. Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.

The single-factor portfolios effectively represent smart beta strategies, which are available to investors via low-cost ETFs. There is little academic support for the Growth factor generating positive excess returns, but it is a widely followed investment style, which war