Implementation Matters

Sep 24, 2018
By David Gibbon, CFA, Jack Davies, CFA, Josephine Smith, PhD, Sara Shores

Relaxing constraints can improve the potential returns of factor strategies

The vast majority of asset pricing literature has examined the returns of factor strategies by constructing hypothetical portfolios formed by ranking or optimizing securities based on stock attributes. In the real world, practical decisions regarding investment vehicles and the resulting constraints may lead to meaningful differences in the returns of factor strategies.

In this paper, we aim to quantify the impact of different investment constraints by showing how well known investment strategies could potentially fare in representative examples of each vehicle type. At one end of the spectrum are Exchange Traded Funds (ETFs), which are most often based upon a low-turnover, fully transparent third-party index. ETFs are traded on an exchange—like a stock—but most indexes are long only and, because they are publicly disseminated, rarely reflect novel or proprietary investment signals. At the other end of the spectrum, private funds often have few constraints. Private funds may take on leverage, take more frequent rebalancing decisions, and selectively disclose information. Between these extremes, institutional investors may have access to a host of different vehicles such as Collective Investment Funds (CIFs), Separately Managed Accounts (SMAs), Funds of One and Mutual Funds.

Our research finds that in many cases, more unconstrained implementations result in higher Sharpe ratios and better downside risk statistics for factor-based strategies. In addition, we find that implementation considerations also affect, potentially to an even higher degree, factor strategies in other asset classes—especially in more illiquid assets. This research highlights how implementation considerations prove to be an important element for investors choosing a practical way to implement factor strategies.

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Jack Davies, CFA
Vice President, Factor-Based Strategies Group
Jack Davies, CFA, Vice President, is a Portfolio Manager for the Factor-Based Strategies Group, managing macro and style factor investment strategies
David Gibbon, CFA
Managing Director, Factor-Based Strategies Group
David Gibbon, CFA, Managing Director, is Head of investment strategy for the BlackRock's Factor-Based Strategies Group in Europe, Middle East and Africa.
Sara Shores, CFA
Managing Director, Factor-Based Strategies Group
Sara Shores, CFA, Managing Director, is Head of Investment Strategy for the Factor-Based Strategy Group, driving the strategy for smart beta across BlackRock.
Josephine Smith, PhD
Director, Factor-Based Strategies Group
Josephine M. Smith, PhD, Director, is on the research team within the Factor Based Strategies Group, responsible for managing risk premia and parity strategies.