In the financial literature, considerable evidence shows that equity tilts toward risk factors such as small size, high value or low volatility can, over time, earn excess returns above capitalization-weighted benchmarks. However, the bulk of this research addresses only the existence of individual factors, and relatively little attention has been paid to how factor-based strategies are best implemented.
The genesis of equity style factors can be traced to the seminal work in 1992 of Eugene Fama and Kenneth French, who proposed that size and value factors are indeed compensated. While the investment community has clearly come to understand the main message of Messrs. Fama and French — that excess returns can be generated from size and value factor tilts — what remains somewhat less understood is the secondary message of this research: that size and value are, in fact, independent sources of excess return.
Recognizing factor independence is critical, for it makes possible the efficacy of multifactor strategies. If returns to small size and high value are indeed independent and uncorrelated, investors can benefit from factor diversification by combining size and value tilts into a single multifactor strategy. In the past two decades other credible risk factors — such as momentum, dividend yield, quality and low volatility — have emerged. Research suggests these style factors are likewise compensated and potentially uncorrelated.
While the benefits of multifactor strategies are uncontroversial, there is little agreement within the industry as to the best approach for implementing multifactor exposure. To date, two primary avenues have emerged:
- Blending of single-factor portfolios. In this approach individual portfolios targeting single style factors are formed and discrete allocations are made to each portfolio. For example, an investor might choose to put 50% of assets in a portfolio targeting high-quality stocks and 50% in a portfolio targeting high-value stocks in order to obtain a multifactor quality/value tilt.
- Multifactor intersection portfolio: In this approach a single portfolio is constructed that targets stocks at the intersection of two or more style factors. For example, an investor might choose to put 100% into a portfolio buying stocks that are simultaneously high quality and high value to obtain a multifactor quality/value tilt.
Which approach is better? In this article we provide a conceptual model and empirical evidence that the blending of single-factor portfolios, although ubiquitous, is suboptimal and multifactor intersection portfolios produce superior results.