We investigate the impact of long-only constraints on portfolio performance in the context of the recent underperformance of equity multi-factor funds.
In Key investment decisions in a multi-factor equity framework, we demonstrated that factor-based investing in stocks is far from being redundant as an investment approach. However, recently and in particular in 2020, exceptional market conditions meant multi-factor strategies with a high allocation to the poorly performing value or size factors were suffered significant underperformance.
In this article, we point out that the very particular conditions in stock markets during 2020 had a specific impact on portfolios with long-only constraints – a constraint common to most multi-factor benchmarked strategies.
We compared the performance of an unconstrained version with that of a long-only constrained version for a multi-factor composite strategy (that is, a combination of individual long/short factor strategies – the factors being; value, quality, low volatility and momentum).
To make this comparison, we used a portfolio optimiser to create long-only constrained benchmarked portfolios with a 2.5% tracking error target.
The optimiser creates a portfolio that replicates the benchmark overlaid with a combination of long/short portfolios (i.e. the portfolio consists of a replication of the benchmark overlaid with the long and short strategies for each of the four factors).
To respect the long-only constraint, the portfolio may only hold underweights in any stock equivalent to the size of that stock’s allocation in the benchmark – net short positions are not permitted – whereas the pure long/short strategy may hold net short positions.
Exhibit 1 shows the information ratios of the constrained portfolios were positive and significant over the period studied, but nevertheless below those of the corresponding pure long-short multi-factor combinations.
The difference reflects the almost inevitable loss in performance due to constraints. Recently, we have seen a larger-than-normal discrepancy between long-only and unconstrained portfolio performance. This, we argue, is partly due to a specific phenomenon related to market concentration and the performance of the low-size factor.
Exhibit 1: Annualised excess monthly returns, tracking error and information ratios of equal risk contribution combinations of beta neutral, macro-sector neutral constant volatility factor styles. World and USA in USD; Europe in EUR; unconstrained and long-only constrained portfolios; no transaction costs; 31 May 2003 through 31 August 2020
Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
Benchmark index concentration can be an issue
Long-only constraints in benchmarked portfolios can create higher exposure to smaller-capitalisation stocks, in particular where concentration (i.e. a small number of large-cap stocks) is pronounced. This is because as concentration increases, it becomes harder to avoid underweighting the largest market-cap stocks to fund other active overweight positions in a long-only portfolio.
Similarly, because shorting stocks is not possible, rising concentration also makes it increasingly difficult to underweight unwanted stocks if their market cap is increasingly smaller. This is what has been happening, in particular in the US and World benchmark indices.
Over the last five years, the five US stocks with the largest capitalisations have doubled in size, leading to levels of concentration not seen since 1990; the 20 largest capitalisation stocks reached levels not seen since the tech bubble some 30 year ago.
Smaller capitalisation stocks have lagged
Following a methodology similar to that described in Equity factor investing: Putting performance into perspective, we simulated the performance of a long-short portfolio strategy that invests in the smaller-cap stocks and sells larger-cap. We used the MSCI World, S&P 500 and MSCI Europe stock universes.
Exhibit 2: Annualised excess returns, tracking error and information ratios of a beta neutral, macro-sector neutral constant volatility size factor portfolio; World and USA in USD; Europe in EUR; no transaction costs; 31 May 2003 through 31 August 2020
Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
Exhibit 2 shows that size factor returns have averaged close to zero over the long term. Over the last year and last three years, returns were poorer, penalising portfolios more exposed to mid-cap stocks than to larger-cap stocks.
The underperformance of the size factor was also a problem for long-only managers, in particular those with a higher tracking error. Inevitably, because of the long-only constraint, they were obliged to overweight smaller-cap stocks to some extent, even if they were not seeking explicitly to allocate to the size factor.
Takeaways
Long-only constraints can detract from performance relative to long-short multi-factor portfolios, even if the returns of long-only portfolios have remained strong over time.
We argue that long-only constraints create additional exposure to small caps, in particular as concentration rises in a benchmark, rendering it increasingly difficult for a portfolio manager to:
(i) Avoid underweighting the largest market-capitalisation stocks in order to fund other active overweight positions.
(ii) Underweight stocks considered undesirable if their market capitalisation is increasingly smaller.
In recent years, and particularly in 2020, the outstanding outperformance of larger-cap stocks in the US and World indices relative to smaller-cap stocks has increased concentration in benchmark indices. As a result, long-only constraints have led to even poorer performance than might have been expected due to an undesired exposure to the underperforming low-size factor.
Also read:
- Equity factor investing: Putting performance into perspective
- Key investment decisions in a multi-factor equity framework
- Light at the end of the tunnel for multi-factor equity investing?
- and our paper “Equity factor investing: Historical perspective of recent performance”
Listen to:
Market weekly – Multi-factor equity investing – Turning the corner (podcast)
