Factor Investing

Various studies recommend investing in factor premiums beyond the classic market risk premium, such as the small-cap, value, momentum, and low-volatility premiums. It is unclear, however, if factor investing can best be implemented using a long-only or a long-short approach. We empirically compare both approaches and find that although a long-short approach is superior theoretically, a long-only approach seems to be the preferred alternative in most scenarios, after accounting for practical issues such as benchmark restrictions, implementation costs and factor decay. In fact, we show that costs and decay may completely offset the value added of a long-short implementation. We conclude that investors should carefully consider the pros and cons of long-only and long-short approaches when implementing factor investing. The framework described in this paper is intended to help investors make that decision.

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