Key Points

  • Our analysis examines combinations of six factors (value, low beta, profitability, investment, momentum, and size) in simple long-only, investable portfolios that reflect real-world strategies. Based on our research, these six factors produce a substantial diversification benefit across return drivers.
  • We find that selecting roughly a quarter of the investable universe based on one specific signal for each factor typically produces the best risk-adjusted performance for a multi-factor strategy in the presence of implementation costs.
  • Neither a focus on maximizing paper portfolio performance, which ignores the associated trading costs, nor a singular focus on low-cost implementation, which misses opportunities for better performance, will produce an optimal result for multi-factor smart beta investors.
  • We strongly advocate the thoughtful design of a multi-factor strategy, which requires a conscious and deliberate decision to find the most advantageous balance between effectively harvesting the factor premium and implementation cost.

One thing is for sure, investing means buying and selling, and these two activities aren’t free. Regardless of how promising the strategy looks on paper, its benefits will be reduced to some degree through its implementation. A worthy goal, therefore, is to limit the toll implementation takes on a strategy’s execution.

Factor investing, also known as smart beta, has become increasingly popular as investors realize they can harvest factor-driven excess returns over the market capitalization-weighted benchmark through a simple, transparent, and rules-based approach. A multi-factor strategy offers a one-stop solution for investors seeking excess returns associated with several factors. The diversifying aspect of combining factors with different risk and return characteristics and low correlations helps investors “weather the storm” during adverse market conditions.1

The goal of not unduly reducing the benefits associated with factor investing by incurring unnecessary transaction costs means adopting real-world product design that is mindful of implementation in the areas related to portfolio concentration, turnover, trading cost, and capacity. In this article we address two questions in the presence of implementation costs: Which factors should be included in a multi-factor portfolio? What is the best way to construct a single-factor portfolio? We find the right balance is achieved by making a conscious decision based on thorough study of the trade-off between the effective harvesting of the factor premium and low cost implementation.

Factor Performance and Correlation
Consistent with Brightman et al. (2017), we include in our analysis six factor-based smart beta strategies: value, profitability, investment, size, low beta, and momentum. Each of these factors is widely deemed robust in the academic literature (Fama and French, 1993, 2012, 2016; Carhart, 1997; and Frazzini and Pedersen, 2014). Profitability and investment, supported by strong academic evidence, are characteristics associated with quality (Hsu, Kalesnik, and Kose, 2019). To illustrate the opportunities presented by investing in real-world strategies, we construct simple long-only investable portfolios in accordance with widely accepted academic practice.