Trade-Off in Multifactor Smart Beta Investing: Factor Premium and Implementation Cost

Abstract

The authors study the impact of the inclusion of the momentum and size factors, and the selectiveness in stock screening, on the performance and implementation cost of a multifactor strategy. Whereas the cost of implementing a stand-alone momentum strategy is quite high because of its extraordinarily high turnover, adding momentum to a mix of the value, low beta, profitability, investment, and size factors helps lower tracking error and improves the information ratio without a significant increase in implementation cost because offsetting trades cancel each other out. Contrary to conventional wisdom, the inclusion of the size factor does not negatively affect the multifactor strategy’s trading costs in light of its relatively low turnover. Additionally, including the size factor improves the performance and coverage of the multifactor strategy, which otherwise would be constructed with only large and mid-size companies. As expected, by using factor portfolios with more concentrated holdings, investors can improve the performance of a multifactor strategy, but these benefits come at the expense of high turnover and high trading costs. The authors specify portfolio design as a conscious choice made on the trade-off between the effective harvesting of the factor premium and low-cost implementation. They highlight the importance of the thoughtful portfolio construction work required to deliver a smart beta multifactor strategy that serves investors’ needs.

TOPICS: Analysis of individual factors/risk premia, portfolio construction, VAR and use of alternative risk measures of trading risk