Factor Investing: The Rocky Road from Long Only to Long Short

Abstract

This paper examines how restrictions on short positions affect the financial attractiveness of factor investing. To fill the gap between unconstrained longshort allocations and restricted long-only portfolios, we consider two in-between strategies. The first imposes that only the market can be shorted; the second is the so-called "130/30" or "active extension" trading strategy, which caps total short exposure at 30%. The takeaways from our research are twofold. First, short sales contribute significantly to the mean-variance performance of efficient factor-based portfolios. Second, the factor portfolios built originally by Fama and French (1992) with the purpose of developing asset pricing are impressively clear-sighted when it comes to portfolio management. Indeed, combining these portfolios generates mean-variance performances similar to those of optimized long-short portfolios, except for low levels of volatility.Keywords: Investment, asset allocation, factor investing, long-only, long-short, 130-30. 2 ABSTRACT This paper examines how restrictions on short positions affect the financial attractiveness of factor investing. To fill the gap between unconstrained long-short allocations and restricted longonly portfolios, we consider two in-between strategies. The first imposes that only the market can be shorted; the second is the so-called "130/30" or "active extension" trading strategy, which caps total short exposure at 30%. The takeaways from our research are twofold. First, short sales contribute significantly to the mean-variance performance of efficient factor-based portfolios.Second, the factor portfolios built originally by Fama and French (1992) with the purpose of developing asset pricing are impressively clear-sighted when it comes to portfolio management.Indeed, combining these portfolios generates mean-variance performances similar to those of optimized long-short portfolios, except for low levels of volatility.3

An Empirical Examination of the Incremental Contribution of Stock Characteristics in UK Stock Returns

“…My examination of the impact of no short selling constraints on the incremental contribution of stock characteristics has taken the extreme cases that the investor can either engage in unrestricted short selling or no short selling. It would be interesting to consider the impact of less stringent short selling constraints on the incremental contribution of stock characteristics to the investment opportunity set as in Briere and Szafarz (2017a) such as 130/30 rule, where there is an upper bound of the total weight of short selling in the risky assets of 0.3. My study has focused on the in-sample performance of the portfolio strategies.…”

“…Since 2012, the EU short selling regulation has banned naked short selling and investors must report net short positions above a certain limit. Briere and Szafarz (2017a) point out that finding a stock lender can be costly and the investor can be exposed to a liquidity shortage (Jones and Lamont 2002). Managed funds such as open-end mutual funds often face legal restrictions on short selling 2 .…”

An Examination of the Benefits of Factor Investing in U.K. Stock Returns

“…The main advantage of sector investing lies in portfolio risk reduction and the main benefit of factor investing lies in higher expected return. Briere and Szafarz (2017c) explore further the role of short selling constraints in factor investing strategies. They find that imposing the Fama and French (1993) constraint (Note 3) on the factors actually leads to good performance and in some cases performs as well as the unconstrained mean-variance optimization.…”

“…The market frictions I examine are no short selling and upper bound constraints on the optimal portfolio weights and proportional transaction costs. I also consider the impact of the less restrictive portfolio constraints used by Briere and Szafarz (2017c).…”

“…Third, when the benchmark investment universe includes the industry portfolios, market frictions tends to eliminate the incremental benefits of factor investing. Fourth, when investors face the more relaxed portfolio constraints of Briere and Szafarz (2017c), factor investing now delivers significant performance benefits to the benchmark investment universe including industry portfolios. My study suggests that market frictions has a significant impact on the performance benefits of factor investing.…”