How can Factors be Combined?
categories: Indexes, Americas, EMEAI, Factor and Risk Modeling, Investing (Investment Management), Portfolio Construction and Optimization, Asia Pacific, Asset Owners, Equities, Research Paper, KULKARNI Padmakar, GUPTA Abhishek, Asset Managers (Quant or Fundamental), DOOLE Stuart, general
Making allocations to individual factors typically requires strong investment beliefs, as factor returns have been cyclical in nature. When weighing the pros and cons of different multi-factor indexed approaches, institutional investors often evaluate both bottom-up or top-down options. We consider the attractions of both, using a bottom-up approach to build a multi-factor index from stocks that are favorably exposed to the value, size, quality and momentum factors, compared with an alternative top-down approach combining single factor indexes. We compare the two approaches in terms of their level of exposure to the target factors as well as their capacity and investability profiles.