Adding alpha by shaping beta
We know that trimming unintended – yet overall harmful – factor risk can improve fund returns as evidenced in a previous research report we wrote, Adding Alpha by Subtracting Beta. This new study goes a step further, testing a refined approach on four equity funds to answer which factor exposures are worth keeping, which are worth reshaping and how to size that adjustment for a specific portfolio.
Does reducing unintended factor risk actually pay off?
Fundamental portfolio managers invest on conviction, but stock selection alone doesn't determine a portfolio's factor exposures. Position sizing, constraints, and the simple act of combining names into a portfolio can create unintended tilts to Value, Momentum, Market Sensitivity, and other style factors – tilts a manager never explicitly chose.
The original Adding Alpha by Subtracting Beta paper showed, using a single real portfolio, that identifying and trimming that unintended factor risk improved realized returns and the information ratio, without touching a single stock call. However, that portfolio happened to carry factors that were dragging on performance. Would the same approach help a portfolio where factors were already working in its favor?
This paper answers that question using quarterly holdings data from four actively managed equity funds between 2020 and 2025. Rather than only minimizing a portfolio's factor risk relative to its benchmark, the extended approach uses each factor's own historical return to decide whether a portfolio's exposure to it is worth keeping, trimming, or reshaping, all within the same modest turnover limits (in addition to the fund’s turnover) as the original paper (as little as 2.5 percent per quarter).
For fundamental managers, the takeaway isn't a case for challenging their convictions. It is a systematic way for a specific portfolio to show how factor-aware adjustments can help its performance.
What you'll get from this report
- A tested method for telling which portfolio factor exposures are helping and which are hurting, using the factor's own history rather than a benchmark comparison
- Results across four real, actively managed equity funds (2020-2025)
- A breakdown of five adjustable parameters (turnover limit, lookback window, threshold, tilt, and multiplier) and how each one changes the outcome
- A framework for deciding whether your own portfolio should avoid known factor drags or actively lean into factor trends
Q&A
Q&A
Does trimming factor risk in a portfolio actually improve returns?
Yes, when done selectively. Research testing this on four real equity funds found meaningful gains from a refined approach that checks each factor's historical performance before deciding whether to trim, keep, or reshape a portfolio's exposure to it.
Q&A
How do you tell if a portfolio's factor exposure is helping or hurting?
By comparing the portfolio's current exposure to a factor against that factor's historical return. This turns a general risk question into a specific one: is this exposure, right now, working for or against this portfolio?
Q&A
Can you reduce unwanted factor risk without overriding a manager's stock picks?
Yes. The adjustments operate within tight position-level limits, with as little as 2.5 percent additional turnover per quarter, so a manager's core convictions stay intact while only the unintended, non-stock-specific factor tilts get reshaped.
Q&A
Does factor-based portfolio construction work on concentrated portfolios with only 20 to 40 holdings?
Yes, it's been tested successfully on concentrated equity funds in this range. Fewer holdings mean less room to maneuver, which makes getting the diagnosis right, not just applying a blanket adjustment, the key to making it work.
Q&A
What's the difference between avoiding factor risk and actively pursuing factor premia?
Avoiding risk means trimming only the exposures that have historically dragged performance down. Pursuing premia means actively tilting toward factors with strong historical returns. Both are viable strategies, and managers can choose where to sit between them based on their own portfolio and risk appetite.
Q&A
How much portfolio turnover is needed to capture a factor-risk benefit?
Modest amounts. Gains were captured with additional turnover limits as low as 2.5 percent per quarter, on the logic that this kind of adjustment should support a manager's existing rebalancing priorities, not compete with them.
Q&A
Should factor-aware adjustments be benchmark-relative, or can they focus on the portfolio alone?
For managers with an absolute return objective, they can focus on the portfolio alone. The diagnostic step that decides whether a factor is worth pursuing or avoiding uses only the portfolio's own exposure and that factor's own history, with no benchmark required.
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