Integrating Factors in Market Indexes and Active Portfolios

Abstract

In this article, the authors review factor performance in global equity markets using coherent data and methodology and apply a new template to evaluate their backtests for potential selection bias under multiple testing. They then propose a systematic process for integrating factor information into different investment strategies. The authors show that this process is consistent with the Black–Litterman framework and test it on a sample of market indexes and active equity portfolios. Integrating factors in indexes improved risk-adjusted performance while retaining high liquidity and capacity. Adding factors to active strategies enhanced information ratios while maintaining the portfolio characteristics and stock selection alpha of the original strategies. The authors’ analysis may have important implications for different types of investors. Asset owners may be able to tilt reference indexes toward rewarded factors without sacrificing market coverage and diversification. Index managers can track factor-tilted indexes because they remain investable and replicable. Finally, active managers may be able to incorporate factor information into their strategies to harvest factor premiums while preserving their core investment process and the added value from fundamental security selection.

TOPICS: Factor-based models, portfolio management/multi-asset allocation, style investing