Can the Whole Be More Than the Sum of the Parts? Bottom-Up versus Top-Down Multifactor Portfolio Construction

Abstract

Rules-based factor portfolios combining multiple factors have become increasingly popular in recent years. One often-asked question concerning portfolio construction is whether combining individual factor portfolios is equivalent to building a bottom-up multifactor portfolio. The latter approach has theoretical merit, because each security’s weight in the portfolio will depend on how well it ranks on multiple factors simultaneously. The former approach, combining single-factor portfolios, may miss cross-sectional interaction between the factors at the security level. The authors analyze the magnitude of these effects and find that these interaction effects can in fact have a significant impact on portfolio performance. Both intuition and empirical evidence favor bottom-up multifactor portfolio construction.

TOPICS: Portfolio construction, analysis of individual factors/risk premia, factor-based models