From Theory to Reality

Summary:

INTRODUCTION

Reality is the murder of a beautiful theory by a gang of ugly facts (Robert Glass, 2002). Factor investing can be considered one of the beautiful theories of the investment world as it is backed by a significant amount of empirical research and can be implemented by investors across markets and asset classes. The gang of ugly facts is that most of the research is based on backtesting, which is full of inherent biases, and investors get charged a variety of fees for accessing the returns from factor investing. In this short research note we will analyse the path from gross to net returns for a long-short multi-factor portfolio.

METHODOLOGY

We focus on four factors namely Value, Momentum, Low Volatility and Quality in the US stock market. The multi-factor portfolio is created via the intersectional model, i.e. by ranking the stock universe by the four factors simultaneously (please see our report Multi-factor Models 101). The portfolio is constructed from the top and bottom 10% of the ranked stocks, is adjusted to achieve beta-neutrality and rebalanced monthly.

MULTI-FACTOR PORTFOLIO PERFORMANCE POST TRANSACTION COSTS

The chart below shows the performance of the long-short multi-factor portfolio before and after transaction costs, which are assumed to be 10 basis points per transaction. Institutional investors can trade for less than 1 basis point per transaction, but the impact costs of executing orders are often multiples of that and should be reflected as well. The portfolio rebalances monthly, but given that the stock selection is based on ranking several factors, the turnover is relatively low.

Source: FactorResearch

MULTI-FACTOR PORTFOLIO PERFORMANCE POST FUND EXPENSES