How should factor-based (style) investors proceed after picking a factor to exploit? In their September 2017 paper entitled “Craftsmanship Alpha: An Application to Style Investing”, Ronen Israel, Sarah Jiang and Adrienne Ross survey style portfolio implementation options. They start with a brief discussion of style portfolios types and then focus on portfolio design and implementation. They note trade-offs associated with many options. Based on past research and examples, they conclude that:
- Investors can approach style investing via:
- Smart beta – long-only tilts that overweight (underweight) stocks with factor values that indicate future outperformance (underperformance).
- Hedge – long (short) stocks with factor values associated with future outperformance (underperformance), generating returns with low correlation to market returns.
- Multi-factor – combines two or more styles, most effectively those with low cross-correlations (such as value and momentum).
- Multi-class – includes assets from multiple classes (such as stocks and bonds) for greater diversification.
- Investors can refine style exploitation by:
- Suppressing noise in an individual factor metric by using several metrics to construct a factor signal.
- Increasing factor portfolio purity by setting more extreme high and low factor percentile cutoffs for stock selection.
- Increasing factor portfolio purity by weighting stocks according to factor value rather than equally or by capitalization.
- Excluding unintended market risk by measuring factor portfolio market beta and hedging via a market index derivative or fund.
- Excluding unintended industry/country risks by building the factor portfolio industry-by-industry and country-by-country (comparing peer assets only).
- Excluding currency risk for international portfolios via currency hedges.
- Investors can achieve more consistent risk-taking via volatility targeting (adjusting cash and factor portfolio allocations according to portfolio volatility). For multi-factor portfolios, applying the volatility target to each style offers more steady diversification.
- Investors employing a multi-factor approach can:
- Mix styles via separate single-factor portfolios.
- Integrate styles by ranking assets separately on each factor and picking only those assets with high or low ranks for all factors.
- Investors can attempt to time factors by allocating more (less) to a style when its expected return is higher (lower) than normal based on, for example:
- The spread in some average valuation metric between factor long and short sides.
- Factor portfolio return momentum.
- Identifying the best economic/market environment for each style.
- Investors must make trade-offs between signal purity and costs of portfolio maintenance.
- The trade-off between signal freshness and portfolio reformation costs may point to an intermediate rebalancing frequency.
- Rebalancing according to some metric that quantifies portfolio drift from style rather than a set frequency may help suppress turnover.
- For large investors, spreading portfolio reformation actions by limiting them to 2% of daily asset trading volume may suppress costs.
- For long-short portfolios, investors may set an upper limit on leverage, scale leverage portfolio volatility, restrict the portfolio to relatively liquid assets and maintain a cash reserve. A plan for handling crises is important.
In summary, investors should consider how style portfolio design and execution choices (setting portfolio weights, managing risks, portfolio reformation details) impact ultimate performance.
Cautions regarding conclusions include:
- As noted in the paper, the best style portfolio implementation options vary by investor.
- Some illustrations in the paper use gross rather than net returns. Conclusions based on net outcomes may differ from those based on gross outcomes.
- Exploring portfolio craftsmanship options arguably equates to elevation of model snooping (opportunities for discovering what is lucky in-sample).
