Accentuate the Positive, Eliminate the Negative: Using Constraints to Amplify Factor-Based Indexes

Abstract

Factor-based indexes tilt toward characteristics that are associated with long-term outperformance, but they are often unable to provide the desired exposures without taking on substantial unintended active risks. The desired factors often carry with them tilts toward particular countries, industries, risk factors, and companies. This problem comes from the relative simplicity of the index construction rules. Although simplicity and transparency are good attributes, for most indexes, there exists no mechanism to control unintended risks. For example, when the value factor is targeted, the portfolio tends to overweight less profitable companies. An investor who wants exposure to inexpensive stocks may receive a portfolio of companies with low or negative profit margins and with concentrations in the sectors and countries that currently happen to have more companies with a lower valuation. In this article, we apply constraints to several factor strategies with an eye toward managing these unintended exposures. We find that constraints reduce the noise and amplify the signal of factor-based strategies.