PT  - JOURNAL ARTICLE
AU  - John T. Scruggs
TI  - Does Neutralizing Style Factors Help or Hurt?
AID  - 10.3905/joi.2021.1.185
DP  - 2021 Jun 07
TA  - The Journal of Investing
PG  - joi.2021.1.185
4099  - https://pm-research.com/content/early/2021/06/07/joi.2021.1.185.short
4100  - https://pm-research.com/content/early/2021/06/07/joi.2021.1.185.full
AB  - It is well known that style factors, such as value or profitability, have natural, incidental exposures to industry, region, and other style factors. These incidental exposures can enhance or detract from the performance of factor-based investment strategies. Knowing whether and how to neutralize these exposures is important for investors. This article disentangles the effects of global style, industry, and region factors using a comprehensive cross-sectional regression framework analogous to the process employed by many systematic investors. In a universe of global, large-capitalization stocks from 1995–2019, neutralizing style factor portfolios unambiguously reduces factor return volatility while maintaining desired factor exposures. For value-related and reversal factors, industry neutralization enhances performance (in terms of information ratio). For intermediate-term momentum and profitability (ROE) factors, industry neutralization diminishes performance by removing the tailwinds associated with significant interindustry effects. The article discusses the reliance of these “pure” factor portfolios on leverage, short positions, and turnover.TOPICS: Factor-based models, global markets, portfolio construction, performance measurementKey Findings▪ Style factors have natural, incidental exposures to industry, region, and other style factors. Some incidental exposures are persistent and some vary widely over time.▪ Industry neutralization enhances the benchmark-relative performance of value-related factors. The benchmark-relative performance of intermediate momentum and profitability (ROE) factors benefit from industry tilts and are diminished when neutralization removes those tilts.▪ Neutralizing style factors diminishes, but does not eliminate, correlations between style factor returns. Thus, some of the benefits of style factor diversification remain after incidental factor exposures are neutralized.