Sequential Model: Sorting by 5 Factors
Pick a Factor, then Tilt, Tilt, Tilt.
February 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- The sequential model ranks stocks by factors sequentially
- Allows investors to prioritise factors and results in concentrated portfolios
- However, the factor sequence matters and only a few factors can be considered
INTRODUCTION
In a recent research report we showed how investors can combine factors into a multi-factor portfolio by ranking for several factors simultaneously (please see Intersectional Model: Sorting by 7 Factors), which results in a portfolio of stocks that rank well on average on the chosen factors. However, some investors have a core philosophy, e.g. are Value investors, and require that all stocks rank highly on this factor. In this case investors can utilise the sequential model, which ranks factors sequentially and allows investors to prioritise specific factors. In this short research note we will analyse the effect of adding an additional four factors sequentially to a Value portfolio in the US.
METHODOLOGY
In this research report we will use the sequential model by sorting stocks for several factors sequentially. We focus on five factors namely Value, Size, Momentum, Low Volatility and Quality and sort in this sequence, which is an arbitrary decision. The factors are created by constructing long-short beta-neutral portfolios of the top and bottom 30% of stocks of the US stock market. Portfolios rebalance monthly and include 10bps of transaction costs.
SEQUENTIAL MODEL
The sequential model ranks stocks by factors sequentially, which means the factor sequence has a significant role on the performance. Investors can prioritise factors as the initial factors have a much larger impact than the later ones. For example, if the first factor is Value, then the stocks in the long portfolio will definitely be cheap stocks, regardless of which factor is used for ranking the stocks thereafter. The graphic below illustrates the sequential model.
