Just one in 10 of all factors are needed to span the entire ‘factor zoo’ with many others being ‘redundant’, according to new academic research.
A paper from Robeco, Lancaster University Management School and the Technical University of Munich, titled Factor Zoo, found the comprehensive set of 153 US equity factors can be compressed to just 15 factors to capture available alpha.
“The selected 15 factors originate from eight out of the 13 factor style clusters, speaking to the heterogeneity of the factor set,” the report said.
“This evidence suggests that many factors are redundant but also that merely using a handful of factors, as in common asset pricing models, is insufficient.”
It added iterative factor models beat common academic models containing the same number of factors by selecting alternative value, profitability, investment or momentum factors or including alternative factor style clusters such as seasonality or short-term reversal.
The research also found newly published factors sometimes supersede older factors, underlining the relevance of factor innovation based on new data and insights.
Interestingly, equal-weighting rather than cap value-weighting factors takes the total number of factors needed to span the entire ‘factor zoo’ to more than 30, suggesting equal-weighted factors exhibit stronger and more diverse alphas, the report said.
Finally, it noted applying the factor strategy to a set of global factors resulted in a similar set of selected factors, however, international factors displayed larger and more diverse alpha.
The research follows a landmark 12 months for smart beta ETFs, which in 2022 booked their best outperformance in more than a decade.
Growth was the only popular factor cluster to underperform market cap-weighted global equities during the year while value, size, momentum, low volatility, quality and multi-factor strategies all outperformed market beta.
