We show analytically and empirically that the long–short investor is more likely to benefit from hedging out sector bets, whereas the long-only investor is more likely to benefit from investing in the factor as it stands.
Across 14 developed-economy countries over the past half-century, the authors analyze the behavior of inflation once a country’s inflation rate surges past various thresholds and study how long a burst of inflation typically lingers. If history is a guide, inflation can take far longer to return to normal levels than most people realize. Transitory inflation is certainly possible, but it is hardly a sensible central expectation. Messaging and policy response from the US Federal Reserve Bank should reflect the relatively high empirical risk that inflation may persist.
Implementation shortfall, whether from trading costs, discontinuous trading, or other frictions, erodes the performance of any investment strategy. These frictions, along with asset management fees, are the main sources of the sometimes-vast gap between live results and paper portfolio performance. Smart beta and factor strategies are not exceptions. In this paper, we investigate how smart rebalancing methods can capture most of the factor premia for a long-only paper portfolio, while cutting turnover and trading costs relative to a fully rebalanced portfolio. We demonstrate the efficacy of prioritizing trades to the stocks with the most attractive signals and of focusing portfolio turnover on the trades that offer the highest potential performance impact.
Although hidden risks of factor investing can lead to investor disappointment, a variety of techniques can improve the risk-adjusted returns of individual factors and factor portfolios. Specifically, a new two-step volatility management approach, coupled with an optimization technique that captures volatility and correlation information, leads to improved risk-adjusted performance, lower volatility of volatility, and improved kurtosis and drawdown characteristics.
Traditional cap-weighted indices generally add stocks with high valuation multiples and sell stocks at low valuation multiples. For the S&P 500 Index, in the year after a change in the index, additions lose relative to discretionary deletions by about 22%. Simple rules, such as trading ahead of index funds or delaying reconstitution trades by 3 to 12 months, can add up to 23 bps. This benefit doubles when a portfolio selected based on the fundamental size of a business or its multi-year average market cap is then cap-weighted.