Top vs Bottom-Ranked Factor Portfolios
Do you need to own the highest-ranked stocks?
- Intuitively, factor exposures should be maximized when seeking outperformance
- While this is true for momentum, it does not apply to the value or size factors
- Investors do not constantly need to rebalance and seek the stocks with the highest factor exposures
INTRODUCTION
Factor investing remains one of the few reliable strategies for generating outperformance over the medium to long term. Yet, constructing a factor-driven portfolio is far from straightforward. Investors must navigate a series of complex decisions, including factor selection, combination methodology, stock weighting, tradable universe definition, rebalancing frequency, and portfolio concentration.
Conceptually, greater portfolio concentration should amplify factor exposures and, in turn, enhance outperformance. However, as we discussed in a previous article, this relationship is not always linear, particularly for the size factor, where returns did not consistently increase when moving from the largest to the smallest market-cap portfolios (read The Illusion of the Small-Cap Premium).
In this research article, we will explore the relationship between factor returns and factor exposures.
FACTOR RETURNS BY PORTFOLIO DECILES
In this analysis, we examine the long-only, market capitalization-weighted returns of the value, size, and momentum factors, using data from the Kenneth R. French Data Library. For each factor, we calculate the compound annual growth rates (CAGRs) across deciles for the period from 1927 to 2024. The top decile (10th) represents cheap, high-performing small-cap stocks, while the bottom decile (1st) reflects expensive, underperforming large-cap stocks.
In theory, we would expect a linear decline in returns from the 10th to the 1st decile. However, this pattern is most clearly observed in the momentum factor, while the value and size factors show more variation across deciles.
