Asset Allocation - Factor Based Approach

The factors commonly used in the factor-based approach generally have low correlations with the market and with each other. This results from the fact that the factors typically represent what is referred to as a zero (dollar) investment or self-financing investment, in which the underperforming attribute is sold short to finance an offsetting long position in the better-performing attribute.

(Institute 158)

Institute, CFA. 2020 CFA Program Curriculum Level III Volume 3. CFA Institute, 08/2019. VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.

The above paragraph completely confuses me. My question is what’s zero (dollar) investment or self-financing investment; and why this approach can be viewed as selling short to finance long.

you short sell a group of underperforming assets and use the proceeds to help offset the cost of other assets you are long. for example, you could rank the stocks by their return over the past year and short sell the bottom 30% and be long the top 30% of the best performing stocks (this is a common strategy known as prior-one-year). you can choose to buy and sell a number of stocks in such a way where the cost of purchase and the amount earned from the short sale exactly offset each other, and that is why is called self-financing i believe. (since you don’t have to pay anything extra initially)

Factors are cyclical in nature. They sometimes are prominent and sometimes fall out of favor. Depending upon your holding period/horizon, you ride th factors that are favorable at the cost of the ones that are not. Don’t look anymore than this. Not relevant.

Let’s take the Fama-French model as an example.

One of the factors used in FFM is the SMB factor, which is the return of a small-cap portfolio (R_Small) minus the return of a large-cap portfolio (R_Large). So SMB (= +R_Small - R_Large) captures the small-cap premium.

Empirical data has shown that small-cap stocks tend to outperform large-cap stocks, so to build the zero-dollar investment / self-financing investment, we will short let’s say $100,000 of the large-cap portfolio (notice the -R_Large?) and invest $100,000 in the small-cap portfolio (hence +R_Small) to capture the small-cap premium.

So, the short position in the large-cap is financing the long position in the small-cap, hence a zero-dollar investment.

this is very helpful, thank you

Hello. Can someone explain me how to identify a factor based approach? i am not able to clearly distinguish it.

On the other hand. Is factor based approach active, pasive or can it fall in both investment strategies?

Thanks in advance

It’s not that it can be viewed as selling short to finance long; that’s what it is in fact.

Suppose that there are two factors: F1 and F2. (Pretty clever, eh?)

Suppose that there are two assets: A and B. They have these factor exposures:

  • A:
    • F1: +1
    • F2: +2
  • B:
    • F1: +3
    • F2: +5

If you want a pure factor F1 portfolio, it’s 2B − 5A; its exposure to F1 is +1, and its exposure to F2 is 0.

If you want a pure factor F2 portfolio, it’s 3A − B; its exposure to F1 is 0, and its exposure to F2 is +1.

Note that each factor portfolio is long/short.

Greetings Miguel, a factor-based approach can be identified by its corresponding model that weights different risk or fundamental factors with each factor getting its own factor beta. See a bunch of factors with factor betas in a model? Well then you’re likely in a factor-based approach my friend.

A passive approach is when you’re mimicking a benchmark index with a focus on tracking well with the index at the cheapest cost to you. In an active approach you’re trying to beat the benchmark, and you’re prepared to pay more cost to unlock higher expected returns. Factor-based approaches have a bit of both. You can create a model that replicates a benchmark index’s risk factors/return drivers. Or you can create a model that isolates for some but not all of those drivers because you think some will over or under perform.

It all depends on how you use the factor model. Many folks in practice look at factor models as some middle ground between active and passive, or a third way to invest aside from active vs. passive.

Cheers - good luck - you got this👍

1 Like