Fundamentals of Efficient Factor Investing (corrected May 2017)

Combining long-only-constrained factor subportfolios is generally not a mean–variance-efficient way to capture expected factor returns. For example, a combination of four fully invested factor subportfolios—low beta, small size, value, and momentum—captures less than half (e.g., 40%) of the potential improvement over the market portfolio’s Sharpe ratio. In contrast, a long-only portfolio of individual securities, using the same risk model and return forecasts, captures most (e.g., 80%) of the potential improvement. We adapt traditional portfolio theory to more recently popularized factor-based investing and simulate optimal combinations of factor and security portfolios, using the largest 1,000 common stocks in the US equity market from 1968 to 2015. Editor’s note: This article was reviewed and accepted by Executive Editor Stephen J. Brown.Editor’s note: Steven Thorley, CFA, became co-editor of the Financial Analysts Journal after the article was submitted but before it was accepted for publication. He was recused from the peer review and acceptance processes. All the necessary measures were taken to prevent Dr. Thorley from accessing any information related to the submission, including the identity of the reviewers. The reviewers were also unaware of his and his co-authors’ identities. For information about the current conflict-of-interest policies, see www.cfapubs.org/page/faj/policies.