Quantra Classroom - Single Factor Limitations? How to Overcome?
Hi QuantInsti,
Welcome to this Quantra classroom, where we delve into the exciting world of combining two factors! In our previous email, we explored the factor approach and created a strategy based on the value factor.
Today, let's continue this fascinating conversation and explore the limitations of a single factor-based approach and how we can overcome it by combining two factors.
All the concepts covered in this email are taken from the Quantra course on Factor Investing: Concepts and Strategies. You can preview the concepts taught in this course by clicking on the free preview button.
Note: The links in this tutorial will be accessible only after logging into quantra.quantinsti.com?
What is the limitation of a single factor-based approach?
Let’s understand this with the help of an example. Suppose you create a strategy based on the value factor. The strategy involves going long on undervalued stocks. The issue with this approach is that it takes a longer-term perspective, and sometimes, undervalued stocks may remain undervalued for longer durations or at least until there are significant changes in the market. The graph below shows the strategy returns of a value factor strategy. We can see no significant change in returns for a very long time.
Just like this, every individual factor has its own drawbacks. For example, a momentum-based strategy will be exposed to a risk due to a crash in momentum. The below performance graph of the momentum factor strategy shows a significant momentum crash during March 2020.
How do we overcome the limitation of a single factor-based approach?
We can overcome this limitation by combining the factors. Let us continue with the above example. Suppose we combine the value and momentum factors and create a combined portfolio. In that case, this portfolio will not only be stable during rough times but also enjoy the exhilarating rides during bull phases.?
Combine momentum and value factors
Combining these factors can be done in two ways. The first approach is straightforward. All you have to do is create an equally weighted portfolio consisting of both value and momentum factor stocks.
To do this, you can follow these steps:
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You can also keep monitoring the performance of your portfolio and tweak the weights to optimise the strategy.
The backtesting and performance analysis for the above approach has been covered in detail along with the Python code in this unit of the Factor Investing: Concepts and Strategies course. You need to take a Free Preview of the course by clicking on the green-coloured Free Preview button on the right corner of the screen next to the FAQs tab and go to Section 17 and Unit 5 of the course.
The graph below shows the strategy returns of the combined portfolio.
The other approach is to filter the stocks based on their value metrics to reduce the number of potential stocks. Then, from this select group, we take positions based on momentum.
So, let’s say we have 100 stocks in our universe. Instead of trading all of them, we apply the value filter and narrow it down to 10 stocks, for example. Now that we have a manageable number of stocks, you can apply the momentum factor to take positions on the stocks that have shown strong recent performance.
And there you have it! We've combined value and momentum to create a focused and well-rounded portfolio.
We have discussed a few approaches to combining factors. In practicality, there might be 100s of factors, many of which might not be relevant. Therefore, we must identify the relevant factors and give them weights based on different metrics. To do this, we can assign weight to the factors based on metrics like the Sharpe ratio, historical returns, etc. We have covered these steps and many such important concepts in our?Factor?Investing: Concepts and Strategies course.
What to do next??
IMPORTANT DISCLAIMER: This article is for educational purposes only and is not a solicitation or recommendation to buy or sell any securities. Investing in financial markets involves risks and you should seek the advice of a licensed financial advisor before making any investment decisions. Your investment decisions are solely your responsibility. The information provided is based on publicly available data and our own analysis, and we do not guarantee its accuracy or completeness. By no means is this communication sent as the licensed equity analysts or financial advisors and it should not be construed as professional advice or a recommendation to buy or sell any securities or any other kind of asset.