Style factor investing has become increasingly popular in recent years. By tilting portfolios towards certain style factors like value, momentum, quality, size etc, investors aim to generate excess returns over the market. However, successfully implementing a style factor investing strategy requires deep understanding of each factor’s characteristics. This article will provide insights into the practical considerations around using style factors in an investment strategy.
Understand the economic rationale behind each style factor
The first key step is to understand the economic rationale behind each factor and how the factor premium is compensation for risk. For example, the value premium exists because value stocks tend to be riskier – they are often cheap for a reason e.g. financial distress. Once the source of risk is understood, investors can better assess the persistence of each factor’s returns.
Evaluate factor characteristics – persistence, pervasiveness, robustness
Before deciding to use a factor, it is critical to evaluate its characteristics thoroughly. Key characteristics to examine are: persistence – does the factor work consistently across long time periods; pervasiveness – does it work globally across countries and asset classes; robustness – does it work for various definitions and parameter specifications. Factors that demonstrate strong persistence, pervasiveness and robustness are more likely to continue working in the future.
Manage risks – diversification, constraints, unintentional bets
Style factor portfolios exhibit higher volatility and significant drawdowns so managing risks is vital. Diversifying across factors with low/negative correlations can help reduce volatility. Constraints can be implemented to limit exposure to unintended risks e.g. limiting sector bets. Portfolio risks should be monitored closely to identify and mitigate unintentional exposures.
Minimize trading costs through portfolio construction
Style factors often have higher turnover, which can significantly erode returns. Careful portfolio construction techniques can help minimize trading costs e.g. using liquid stocks, avoiding unnecessary rebalancing, using wider bid-ask spreads. Execution algorithms and Benchmarks can further optimize trade implementation to reduce market impact.
Regularly rebalance and revisit definitions
Style factors experience periods of underperformance so a disciplined rebalancing approach is required. As new research emerges, factor definitions may need enhancement to retain efficacy. For example, combining factors can create more robust multi-factor portfolios.
Successfully implementing style factor investing requires thoroughly evaluating factor characteristics, managing risks carefully, minimizing trading costs through portfolio construction, rebalancing regularly and continuously revisiting factor definitions.