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Article

Multifactor Index Construction: A Skeptical Appraisal of Bottom-Up Approaches

Noël Amenc, Felix Goltz and Sivagaminathan Sivasubramanian
The Journal of Index Investing Summer 2018, 9 (1) 6-17; DOI: https://doi.org/10.3905/jii.2018.9.1.006
Noël Amenc
is a professor of finance at EDHEC-Risk Institute and chief executive officer at ERI Scientific Betain Singapore
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Felix Goltz
is head of applied research at EDHEC-Risk Institute and a research director at ERI Scientific Betain Nice, France
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Sivagaminathan Sivasubramanian
is a senior quantitative research analyst at ERI Scientific Beta in Nice, France
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Abstract

In this article, the authors contrast the claims of promoters of “bottom-up” approaches for constructing multi-factor equity portfolios with relevant findings in the academic literature. In particular, the authors review findings in the academic literature that raise questions on the reliability of the link between factor scores and returns, on possibilities of overstating the backtest performance of bottom-up portfolios, and on the cost of concentration resulting from the chase of factor champions. The article shows that, while bottom-up approaches are driven by a naïve belief into a fine-grain deterministic link between stock-level multi-factor exposures and returns, the empirical evidence in the asset pricing literature only supports the existence of a broad-stroke relationship. Moreover, it is emphasized that bottom-up approaches are prone to over-fitting and multiple testing biases. Without any adjustments for such biases, the backtest results of bottom-up approaches may be overstated. Finally, in the process of chasing factor champions, bottom-up portfolios tend to become highly concentrated while the academic literature stresses that diversification is crucial for the successful harvesting of factor premia. The authors conclude that findings in the academic literature on these three questions give rise to a healthy dose of skepticism concerning the superiority claims of bottom-up proponents.

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The Journal of Index Investing: 9 (1)
The Journal of Index Investing
Vol. 9, Issue 1
Summer 2018
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Multifactor Index Construction: A Skeptical Appraisal of Bottom-Up Approaches
Noël Amenc, Felix Goltz, Sivagaminathan Sivasubramanian
The Journal of Index Investing May 2018, 9 (1) 6-17; DOI: 10.3905/jii.2018.9.1.006

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Multifactor Index Construction: A Skeptical Appraisal of Bottom-Up Approaches
Noël Amenc, Felix Goltz, Sivagaminathan Sivasubramanian
The Journal of Index Investing May 2018, 9 (1) 6-17; DOI: 10.3905/jii.2018.9.1.006
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  • Article
    • Abstract
    • DOES IT MAKE SENSE TO ACCOUNT FOR FINE-GRAIN DIFFERENCES IN FACTOR EXPOSURES?
    • COULD THE BACKTEST PERFORMANCE OF BOTTOM-UP APPROACHES BE OVERSTATED?
    • WHAT IS THE COST OF PURSUING FACTOR CHAMPIONS RATHER THAN DIVERSIFICATION?
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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