Tuesday, December 3, 2019

Factor investing kept simple - Forget the shorts and focus on the hedged longs

Forget the shorts and only focus on the long positions for key equity factor premia. This simple conclusion may be one of the more important practical research papers for 2019. It is simple direct and highly useful. Many investors may say that this conclusion is obvious. It is almost always the case that simple conclusions are often viewed as obvious after the fact, the hindsight bias. However, this result is compelling in the face of increasing complexity by some factor strategies. 

In the paper, "When equity factors drop their shorts" the authors from Robeco Asset Management focus on the simple key factors in equity markets, value, momentum, profitability, investment, and volatility over a long period across both US and international markets. They decompose factor premia into long, short, and combination long/short portfolios. The long and shorts are hedged against an appropriate benchmark. The results show that a hedged long position will have a better Sharpe ratio than the classic long/short factor portfolio. The short portfolios are positive, and in some cases, better than the long portfolios; however, the short combination of factors are inferior.

Most investors know how hard it is to run a short portfolio. Performance is usually lower, transaction costs are higher, and management requires more time. An investor's life can be so much simpler if the short portfolio was abandoned. A complete withdrawal creates 

Now, these effects have been well-known, but there has been a focus on the purity of a market neutral portfolio where cheap stocks are bought and rich are short for a given factor. An interesting feature is that the correlations of short positions across factors are much higher than for long positions. This is one of the drivers for why the bundle of long factors has a higher Sharpe ratio. Long/short combinations can do fine, but if factors are bundled, the portfolio may not do as well as a long-hedged combination.

This research conclusion allows investors to focus on factors through a long-hedged portfolio without guilt. This work does not dispel the risk premia in key equity factors rather it just highlights issues associated with short selling. This conclusion may be obvious, but it should provide deeper thought for how a portfolio should be constructed.

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