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

Practical Applications Summary

In Trade-Off in Multifactor Smart Beta Investing: Factor Premium and Implementation Cost, from the 2019 Quantitative Special Issue of The Journal of Portfolio Management, Feifei Li and Joseph (Yoseop) Shim (both of Research Affiliates) investigate the effects of implementation costs on multifactor portfolio construction. They examine the performance impact of rebalancing multifactor portfolios by looking at portfolio characteristics such as volume, tilt, turnover, and turnover concentration. They find that multifactor portfolios that included all six style factors under consideration—value, low beta, profitability, investment, momentum, and size—yielded the highest information ratios, both before and after trading costs, with a very small negative impact on Sharpe ratios compared with multifactor portfolios composed of fewer factors. The authors also determine that a uniform concentration level of 25% for all factors provides the greatest performance in the presence of implementation costs. Overall, they suggest investors pursue multifactor portfolios composed of the top 25% of stocks in each of the six style factors.