Inverting Factor Strategies

Factor exposures drive the performance of diversified portfolios. This paper analyses the paradox of portfolio strategy weight inversion and explains why beating the market is not so easy that “a monkey could do it”.

Summary

Factor investing is a simple concept. Put simply, factor exposures drive the performance of diversified portfolios. With a construction technique that furnishes the ability to achieve precise and controlled factor exposures, it is possible to readily construct factor strategies—and their opposites—in a transparent manner. Some key points in this paper include:

• Stock weighting schemes in a portfolio have a profound effect on factor exposures and, hence on the portfolio performance. Popular weighting schemes create unintended and potentially undesirable factor exposures.
• Mere inversion of the stock weights of a portfolio does not invert a portfolio’s factor exposures. Using a factor tilting methodology, we demonstrate that it is possible to produce portfolios with precisely opposite factor exposures.
• The magnitude of the factor exposures has a direct impact on the portfolio performance outcomes. 
• Factor exposures resulting from the interaction of stock selection and stock weighting schemes explains the phenomenon of Malkiel’s Monkey portfolio.