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Key investment decisions in a multi-factor equity framework

When it comes to building an efficient and consistent multi-factor equity strategy, investors need to decide which factors to use and how to diversify their exposure. This determines the long-term risk-adjusted performance of the strategy.

How do such choices affect multi-factor strategies?

Let’s first look at the impact of beta and macro-sector neutrality and constant risk compared to a simpler approach. We will compare the information ratios of

  • long-short multi-factor combinations where all factors are beta-neutral, macro-sector neutral and target a constant 2.5% volatility at each rebalancing
  • strategies that differ only by not imposing beta and sector neutrality and by replacing the targeting of constant volatility by a constant level of leverage.

We call the first Neutralised and the second Raw. Both strategies rely on an equal risk contribution allocation to the four factor styles.

Exhibit 1: Information ratios of unconstrained long-short neutralised and raw factor portfolios, rebalanced monthly – World and US in USD and Europe in EUR; no transaction costs; 31 July 1995 - 31 August 2020

Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.

Exhibit 1 shows that the risk-adjusted returns tend to be significantly higher for neutralised factors strategy than for raw factors, the only exception being value in the US. In the case of low volatility, the information ratios is zero for the raw factors strategy. Without neutralising beta, the raw factors have a negative beta and a negative exposure to the equity risk premium detracts from performance.

It is remarkable how sophistication almost doubles the risk-adjusted returns of the multi-factor combinations over a 25-year period. It appears that neutralising beta and macro-sectors and targeting constant volatility significantly helps over the long term.

What about the impact of diversification?

Diversifying the underlying indicators used in each factor increases the risk-adjusted returns. To demonstrate this, we compare the information ratios of the combination of indicators used in our proprietary model, with simpler strategies with a single indicator per factor:

  • price-to-book – value
  • return on capital employed (ROCE) – quality
  • 12-month returns minus 1-month returns – momentum
  • historical volatility – low risk.

Other than that, both strategies rely on the exact same assumptions.

Exhibit 2: More diversified strategies have significantly higher risk-adjusted returns, particularly for the US and World – Information ratios of unconstrained long-short factor portfolios, rebalanced monthly, beta neutral, macro-sector neutral and targeting 2.5% ex-ante volatility; World and US in USD and Europe in EUR; no transaction costs; 31 July 1995 – 31 August 2020

Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.

And the size factor?

Adding the true size factor would require investing in small-capitalisation stocks. We choose not to do so because this would significantly reduce the capacity to invest and would likely pose liquidity issues.

Furthermore, our research does not suggest the existence of a premium to be earned from a size tilt. The returns in the last three years have been poor, penalising portfolios that were more exposed to mid-capitalisation stocks than to larger-cap stocks.

However, we know that long-only constraints in benchmarked portfolios cause some almost inevitable exposure to the smaller caps, in particular as the concentration of benchmark indices grows. Concentration makes it increasingly difficult to avoid underweighting the largest market-cap stocks to fund active overweight positions in long-only portfolios.

Similarly, because shorting stocks is not possible, concentration makes it increasingly difficult to underweight unwanted stocks if their market capitalisation is increasingly smaller. This is what has been happening in particular in the US and World benchmark indices.


Value, quality, low risk and momentum are factors styles with demonstrated efficacy in identifying stocks that can outperform. Adding the size factor applied to mid and large-cap stock benchmarks does not improve performance, but reduces the capacity of the strategies and risks liquidity issues.

The choice of style factors, neutralising sectors and market beta, control of the tracking error and diversification play an important role in improving the performance of equity factor strategies.

In the next article, we look at the impact of typical portfolio constraints on recent multi-factor strategy performance. It appears a long-only constraint is likely to have pushed performance further into negative territory.

Also read:

Listen to:

Market weekly – Multi-factor equity investing – Turning the corner (podcast)

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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