FAA Multi-Factor Ranking: Combining Return, Volatility, and Correlation

The FAA multi-factor ranking system, developed by Wouter Keller and Hugo van Putten (SSRN #2193735), evaluates assets across three independent dimensions: trailing return (momentum), trailing volatility (risk), and trailing correlation with other universe members (diversification). Each dimension is ranked independently, and the ranks are combined using configurable weights to produce a composite score that captures a more complete picture of an asset's attractiveness than any single factor alone.

How It Works

Each month, all assets are ranked on three criteria using four-month trailing data. Return rank: assets with higher trailing returns receive higher ranks. Volatility rank: assets with lower volatility receive higher ranks. Correlation rank: assets with lower average correlation to other assets receive higher ranks. The composite score combines these: Score = 1.0 × ReturnRank + 0.8 × VolatilityRank + 0.6 × CorrelationRank.

The weighting hierarchy ensures momentum remains the primary selection criterion while volatility and correlation provide meaningful adjustments. An asset with moderate returns but exceptionally low volatility and correlation can outrank a higher-returning asset that is volatile and highly correlated.

Why Multi-Factor Beats Single-Factor

Pure momentum selection ignores risk information that is directly relevant to portfolio outcomes. Two assets with identical 10% trailing returns contribute very different amounts of risk to a portfolio if one has 8% volatility and the other has 20% volatility. Similarly, two assets with identical returns but different correlations provide different diversification value. The FAA approach captures these distinctions, selecting assets that offer the best combination of return, stability, and portfolio-level diversification.

Strategies That Use FAA Multi-Factor Ranking

• Flexible Asset Allocation (FAA) — the original implementation, 7-asset universe, top 3 by composite score

The FAA approach influenced subsequent strategies including the EAA family, which replaced the additive rank combination with a multiplicative formula for sharper differentiation.

The Four-Month Lookback

FAA uses a notably short four-month lookback for all three factors — substantially shorter than the twelve-month standard in most tactical strategies. This makes the signal more responsive to recent changes but also more sensitive to short-term noise. The short lookback reflects Keller's view that the most actionable momentum information is concentrated in recent price behavior, and that extending the lookback dilutes this information with stale data. The trade-off is higher turnover and more frequent false signals than longer-lookback alternatives.