Signals for the Winners and Losers: the Outperformance of Overlapping Portfolios

Stocks sorted into the same extreme portfolios of multiple characteristics make factors overlapped. I disentangle these stocks from uniquely sorted ones when forming multi-factor strategies. I find that portfolios containing stocks with multiple signals outperform stocks with a unique signal. The multi-signal long-short strategy, which goes long and short in stocks exhibiting multiple signals, delivers a higher Sharpe ratio than the naive approach that equally invests in all factors. On the other hand, the uni-signal long-short strategy, which goes long and short in stocks exhibiting a unique signal, delivers a lower Sharpe ratio. Adding returns on the multi-signal long-short portfolio to the CAPM with size factor significantly improves pricing individual characteristic-sorted portfolios. By contrast, adding returns on the uni-signal long-short portfolio only yields a similar explanatory power to the benchmark. The multi-signal portfolio is also beneficial for diversification, as it spans the uni-signal portfolio in all positions. The downside risk measures show that multi-signal stocks experience lower potential losses in the long position but higher potential losses in the short position than uni-signal stocks. All these findings imply that overlapping portfolios which contain stocks with multiple signals drive the performance of factor investing strategies.