Practical Applications of The Capacity of Factor Strategies

Practical Applications Summary

In The Capacity of Factor Strategies, from the September 2019 issue of The Journal of Portfolio Management, David Blitz and Thom Marchesini, both of Robeco Asset Management, examine factor-investing strategies and the capacities needed to process these increasingly popular approaches. Focusing their research on the low-volatility factor, the authors conduct a simulation alongside current minimum-volatility indexes, with the simulation’s trades occurring more frequently and over a longer period than is currently standard with factor indexes. The simulation shows no performance loss and considerable capacity expansion over standard minimum-volatility indexes. The authors also conduct simulations with quality and value factor indexes, with similar results.

The authors surmise that index-based factor strategies are currently subject to pronounced capacity constraints because most trades occur on just a few active days of rebalancing each year. This leads to liquidity squeezes and ultimately compromised returns. To add capacity and ameliorate these conditions, the authors advise implementation of more sophisticated factor-investing strategies, including more frequent rebalancing. They suggest spreading out trades over a larger number of days during the year to continuously leverage latent market liquidity. Active, frequent trading in smaller amounts, the authors advise, promotes greater capacity than more passive factor-index replication strategies that make infrequent but much larger trades.

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