Bottom-up versus top-down factor investing: an alpha forecasting perspective
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ORIGINAL ARTICLE
Bottom‑up versus top‑down factor investing: an alpha forecasting perspective Martin Zurek1 · Lars Heinrich2 Revised: 21 September 2020 / Accepted: 9 October 2020 © The Author(s) 2020
Abstract In a recent discussion about efficient ways to combine multiple firm characteristics into a multifactor portfolio, a distinction was made between the bottom-up and top-down approach. Both approaches integrate characteristics with equal weights and ignore interaction effects from differences in informational content and correlations between the firm characteristics. The authors complement the bottom-up approach for the missing interaction effects by implementing a linear alpha forecasting framework. Bottom-up versus top-down factor investing is typically discussed using the assumption that all characteristics are equally priced, but the pricing impact of different firm characteristics can vary tremendously. The alpha forecasting perspective provides a theoretical motivation for factor investing and helps to compare the bottom-up and top-down approach with regard to the difference of informational content and interaction effects between firm characteristics. Taking into account the difference in informational content between firm characteristics leads to significant performance improvement in factor models with a high concentration of informational content. Equally weighted characteristics result in related performance irrespective of whether the bottom-up or top-down approach is applied. Keywords Factor investing · Top-down · Bottom-up · Smart beta · Multifactor · Alpha forecasting · Stock screening · Z-score · Information coefficient · Optimal orthogonal portfolio JEL classification G11 · G12 · G15 · G17 Factor investing, which is also called smart beta, aims to improve capitalization-weighted portfolios by tilting portfolio weights toward specific risk factors. Advocates of factor investing refer to well-performing backtest results caused by low-cost factor exposures. While cost-efficiency is a result of the rules-based approach, an overly simplistic adaptation of factor investing strategies can lead to many missconceptions,1 especially in cases of the implementation of multifactor strategies.
* Martin Zurek zurek@europa‑uni.de Lars Heinrich [email protected] 1
Department of Finance and Capital Market Theory, European University Viadrina, Große Scharrnstraße 59, 15230 Frankfurt (Oder), Germany
Department of Liquid Assets, W&W Asset Management, Wüstenrotstraße 1, 71638 Ludwigsburg, Germany
2
In a recent discussion about efficient ways to combine multiple firm characteristics into a multifactor portfolio, the top-down (TD) and bottom-up (BU) approach were differentiated. The TD method is a two-step approach that first builds the single-factor portfolios and then combines them into a multifactor portfolio. In contrast, the one-step BU approach integrates all firm characteristics simultaneously into a multifactor portfolio. Across the recent literature, there has been no consensus on the s
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