The Capacity of Factor Strategies

Abstract

The rapidly growing popularity of factor investing raises questions about the capacity of factor-based strategies. In this article, the authors show that widely used factor indexes face severe capacity constraints as a result of concentrating all their trades on just a handful of rebalancing moments each year. They argue that the key to unlocking a high capacity is efficiently using the liquidity offered by the market throughout the year. This is illustrated with a simulation experiment in which the trades of standard factor indexes are simply spread over a longer period. Although this naive approach uses stale information, no loss in performance is observed and trade feasibility, and hence capacity, show spectacular improvement.

TOPICS: Factor-based models, style investing, analysis of individual factors/risk premia