Passive Implementation of Factor Diversification Strategies

Abstract

Benefiting from low or negative active-return correlations across factors, factor diversification strategies deliver superior risk-adjusted performance compared to individual component factors, as well as other strategies with concentrated factor exposures, while considerably mitigating market underperformance risk. We discuss the passive implementation of two diversification strategies: 1) a momentum and value diversification strategy, and 2) a volatility, momentum, and value diversification strategy. We show that a capitalization-weighted, high-capacity implementation produces higher after-cost Sharpe ratios than the market and information ratios that approach 0.40. A high-efficiency implementation also realizes higher after-cost Sharpe ratios than the market and yields information ratios that approach 0.70. The passive implementation of factor diversification strategies represents an opportunity for investors to realize significant value added in the equity portfolio in a transparent and cost-effective fashion.

TOPICS: Factor-based models, VAR and use of alternative risk measures of trading risk, passive strategies