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Factor investing: alpha concentration versus diversification

Author

Listed:
  • Lars Heinrich

    (W&W Asset Management GmbH)

  • Antoniya Shivarova

    (European University Viadrina)

  • Martin Zurek

    (European University Viadrina)

Abstract

Despite extensive research support, the role of diversification in current factor investing strategies remains neglected. This paper investigates whether well-designed multifactor portfolios should not only be based on firm characteristics, but should also include portfolio diversification effects. While the alpha concentration approach mainly considers factor-specific firm characteristics, the diversified approach utilizes covariance estimators in addition to firm characteristics to account for portfolio diversification. The corresponding out-of-sample results show that including an efficient covariance estimator improves the performance of long-only multifactor portfolios compared to the pure alpha concentration approach. A particular advantage of diversified factor investing strategies can be identified in the significant increase in exposure to the low-volatility factor represented by firm characteristics with high informational content. No significant performance differences are observed for long-short portfolios where the factor exposures of the alpha concentration and diversification approaches are similar with respect to the low-volatility factor.

Suggested Citation

  • Lars Heinrich & Antoniya Shivarova & Martin Zurek, 2021. "Factor investing: alpha concentration versus diversification," Journal of Asset Management, Palgrave Macmillan, vol. 22(6), pages 464-487, October.
    • Handle: RePEc:pal:assmgt:v:22:y:2021:i:6:d:10.1057_s41260-021-00226-0
    DOI: 10.1057/s41260-021-00226-0
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    References listed on IDEAS

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    Cited by:

    1. Lee, Tae Kyun & Sohn, So Young, 2023. "Alpha-factor integrated risk parity portfolio strategy in global equity fund of funds," International Review of Financial Analysis, Elsevier, vol. 88(C).

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    More about this item

    Keywords

    Factor investing; Alpha forecasting; Diversification; Optimal orthogonal portfolio; Information coefficient; Covariance;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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