Factor Neutrality

Abstract

Investors have views on both factor returns and stock-specific returns, and the results they achieve may reflect both return components to varying degrees. Attempting to eliminate the impact of a particular factor may not be desirable. Application of an analytical framework to consider the potential deterioration in investment performance suggests a substantial loss in information ratio due to enforcement of factor neutrality, particularly with a limited number of stocks in a portfolio, as is often the case in the real world. The IR may be affected even if all information available is on stock-specific returns, when different universes are used to estimate the factor structure and to construct the portfolio. Maintaining factor neutrality can be suboptimal.