Accounting for Cross-Factor Interactions in Multifactor Portfolios without Sacrificing Diversification and Risk Control

Abstract

In this article, the authors compare different approaches for constructing multifactor equity portfolios: bottom-up score-weighting approaches that target high-factor intensity and top-down approaches that also consider diversification objectives. They find that focusing solely on increasing factor intensity leads to inefficiency in capturing factor premia, because exposure to unrewarded risks more than offsets the benefits of increased factor scores. High factor scores in bottom-up approaches also come with high instability and turnover. The authors introduce an approach that considers cross-factor interactions in top-down portfolios through an adjustment at the stock-selection level. While producing lower factor intensity than bottom-up methods, this approach leads to higher levels of diversification and produces higher returns per unit of factor intensity. The authors report that it dominates bottom-up approaches in terms of relative performance, while considerably reducing extreme relative losses and turnover.