Why Fama-French Long-Short Factors May Retain Market Beta

Summary

The note explains why a long-short factor portfolio such as SMB or HML is not necessarily market neutral. The factors are assembled from six portfolios formed by sorting stocks on size and book-to-market, rather than by explicitly targeting zero market exposure. A portfolio can have little or no net cash investment while still carrying market beta, because its long and short legs may have different sensitivities to the market. The example is that small and large companies can have different betas, leaving SMB with nonzero aggregate exposure.

To target beta neutrality, the answer proposes estimating constituent betas and reweighting the six component portfolios so each has market beta of one. Long-short combinations of those beta-matched portfolios would then have zero market beta under the stated construction. The response notes that an optimizer can help with reweighting, but does not specify an estimation window, constraints, transaction costs, or how estimated betas may change over time. Beta neutrality also does not imply neutrality to other risk factors.

Key ideas

• Fama-French factors are constructed from size and book-to-market sorts, not to guarantee market neutrality.
• A zero-net-investment long-short portfolio can still have nonzero market beta.
• Differences in beta between long and short constituents can create aggregate market exposure.
• Reweighting the component portfolios to a common market beta can produce beta-neutral long-short combinations.
• Estimated beta neutrality depends on the measurement and portfolio construction choices.

Tags

# Are Fama French Factors market neutral?


# Are Fama French Factors market neutral?












I was wondering whether the famous fama-french factors such as e.g. SMB and HML are market neutral? I know that they are long-short factors in the sense that the net investment is essentially zero, but I was wondering if this also makes them market neutral?

If not, how to make them market neutral?

Bonus: is it also possible to make them beta neutral?

## Answer by Tim Wilding (score 7, accepted)

https://quant.stackexchange.com/a/51244

The factors are not constructed to be market neutral. The factors are constructed from 6 subportfolios sorted by book-to-market and size. You can read more about how the factors are constructed at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_factors.html.

Given that the Fama-French factors are long-short portfolios, it might be reasonable to expect that $\beta_{Mkt}$ for these portfolios would be close to zero. However, the underlying factors may cause significant differences in $\beta_{Mkt}$ for the long and short portfolio. So, for example, small stocks are likely to have a significantly different $\beta_{Mkt}$ to large stocks, and the resultant SMB factor will have an overall $\beta_{Mkt}$.

If you wish to make the resultant portfolios $\beta_{Mkt}$ neutral, you can calculate the $\beta_{Mkt}$ for all of the constituents and reweight the members of each of the 6 subportfolios so that all 6 have a $\beta_{Mkt}$ of 1. There are many ways of doing this if you have access to an optimizer. Any long-short portfolios constructed from those portfolios will then have a $\beta_{Mkt}$ of 0.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.