Diversified or Concentrated Factor Tilts?

The authors compare two approaches to singlefactor index design: concentrated and diversified indices. From a conceptual perspective, the authors emphasize several issues with highly concentrated portfolios. Concentration in a few stocks reflects high confidence in the precision of the link between expected returns and factor exposure, whereas expected returns are notoriously difficult to estimate precisely. Moreover, the empirical assetpricing literature emphasizes the need to construct broad portfolios that are not unduly influenced by a small number of stocks. The authors' empirical analysis compares broader and more narrow stock selections, as well as two different weighting schemes, equalweighting and capweighting. Their results show that concentrated factortilted portfolios come with problems. Trying to improve a capweighted factortilted portfolio's performance by selecting fewer stocks that are most strongly tilted to the factor does not have any effect on riskadjusted performance. With concentration, returns and risk increase. However, concentration leads to problems such as higher turnover, high idiosyncratic risk, and longer times to trade. Conversely, achieving concentration through a move to equalweighing leads to higher Sharpe and information ratios, with only marginally higher turnover levels. © 2015 Institutional Investor LLC. All Rights Reserved.