Multifactor Index Construction: A Skeptical Appraisal of Bottom-Up Approaches

In this article, the authors contrast the claims of promoters of “bottom-up” approaches for constructing multi-factor equity portfolios with relevant findings in the academic literature. In particular, the authors review findings in the academic literature that raise questions on the reliability of the link between factor scores and returns, on possibilities of overstating the backtest performance of bottom-up portfolios, and on the cost of concentration resulting from the chase of factor champions. The article shows that, while bottom-up approaches are driven by a naïve belief into a fine-grain deterministic link between stock-level multi-factor exposures and returns, the empirical evidence in the asset pricing literature only supports the existence of a broad-stroke relationship. Moreover, it is emphasized that bottom-up approaches are prone to over-fitting and multiple testing biases. Without any adjustments for such biases, the backtest results of bottom-up approaches may be overstated. Finally, in the process of chasing factor champions, bottom-up portfolios tend to become highly concentrated while the academic literature stresses that diversification is crucial for the successful harvesting of factor premia. The authors conclude that findings in the academic literature on these three questions give rise to a healthy dose of skepticism concerning the superiority claims of bottom-up proponents.