{"id":38705,"date":"2014-12-05T10:12:04","date_gmt":"2014-12-05T09:12:04","guid":{"rendered":"http:\/\/beta.next-finance.net\/strategie\/risk-factor-investing-explained\/"},"modified":"2019-12-30T23:14:42","modified_gmt":"2019-12-30T22:14:42","slug":"risk-factor-investing-explained","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/strategie\/risk-factor-investing-explained\/","title":{"rendered":"Risk factor investing explained"},"content":{"rendered":"

Almost all of the performance of diversified
\nportfolios, across both equities and fixed
\nincome, could be explained by factors<\/quote><\/p>\n

RISK FACTORS HELP US TO UNDERSTAND THE MARKET<\/h2>\n

Risk factors help explain systematic return patterns in the
\nequity market and in other asset classes.<\/p>\n

In traditional finance theory, such as the Capital Asset Pricing
\nModel (CAPM) that was set out by Treynor, Sharpe and others
\nin the 1960s, there is a single equity market risk premium,
\nmeasured by beta. This risk premium compensates investors
\nfor holding equities rather than less risky assets. An investor
\ncan capture the equity market risk premium by holding the
\nmarket portfolio of stocks.<\/p>\n

But since CAPM was introduced researchers have put
\nforward convincing evidence that there are other systematic
\nsources of return in the equity markets than simply the
\nmarket beta. These alternative return premia, or risk factors,
\ninclude those relating to stocks\u2019 size, their valuation, their
\nmomentum and their historical riskiness.<\/p>\n

So now we can talk about \u201csmart beta\u201d: a combination of
\nmarket beta and alternative risk premia representing these
\nother factors.<\/p>\n

Smart beta = market beta + alternative risk premia<\/strong><\/p><\/blockquote>\n

Factor investing means the attempt to capture particular
\nfactor risk premia in a systematic way, for example by
\nbuilding a factor index and replicating it, or by constructing
\na portfolio that gives you exposure to a range of risk factors.
\nThe objective is to combine factors to enhance the long-term
\nperformance of portfolios.<\/p>\n

FACTOR INVESTING IS A SUBSET OF SMART BETA<\/h2>\n

Factor investing, including factor indices, are part of the
\nsmart beta trend. But smart beta goes beyond factors.<\/p>\n

Smart beta indices include all indices that depart from the
\ntraditional method of weighting components by their market
\ncapitalisation\u2014companies\u2019 individual stock market footprint.<\/p>\n

Equally weighted, minimum variance indices, maximum
\nSharpe ratio and equal risk contribution indices are all part
\nof smart beta. Many of these index approaches have factor
\n\u201ctilts\u201d but they are a by-product of the index design.<\/p>\n

In contrast, factor indices are those that are designed
\nintentionally to capture a specific risk premium, such as
\nvalue, size, low volatility, quality or momentum.<\/p>\n

FACTORS AND ACTIVE MANAGEMENT<\/h2>\n

Factor investing has attracted a lot of interest because the
\npast performance of traditional active managers seems to
\nbe due in a large extent to exposure to particular risk premia.
\nThere\u2019s a lot of evidence that the average active manager
\nhas had long-standing exposure to particular factors, such
\nas size and momentum.<\/p>\n

For example, an influential study of the past performance
\nof the Norwegian Government Pension Fund, published
\nin 2009, showed that almost all of the performance of the
\nfund\u2019s external managers, across both equities and fixed
\nincome, could be explained by factor \u201ctilts\u201d.<\/p>\n

This observation raises an important question. If a fund\u2019s
\nperformance can be attributed in large part to a combination
\nof return factors, why not seek to replicate the factors in a
\nsystematic and low-cost way? We are seeing a lot of interest
\nin doing just this via smart beta indices and ETFs.<\/p>\n

I don\u2019t want to downplay the role of active investors altogether.
\nThis type of fund management will always play an important
\nrole. But active managers should be rewarded for taking truly
\nidiosyncratic risks.<\/p>\n

DON\u2019T GET LOST IN THE FACTOR ZOO<\/h2>\n

In their influential 1992 paper, \u201cCommon Risk Factors in the
\nReturns on Stocks and Bonds\u201d, Eugene Fama and Kenneth
\nFrench showed that, in addition to the market risk premium,
\ntwo other factors relating to firms\u2019 size and to value help to
\nexplain stock returns.<\/p>\n

Since then, researchers have provided evidence for the
\nexistence of other factors, including momentum, low volatility
\nand quality.<\/p>\n

Momentum is a well-documented tendency for persistence in
\nstocks\u2019 price returns: stocks that have recently outperformed
\ntend to continue to do so for some time. The low volatility factor is a return stream associated with less risky stocks
\nand the quality factor represents the performance of a
\nsubset of more defensive stocks.<\/p>\n

But statistical analysis can be and has been used to claim the
\nexistence of more and more factors. In fact John Cochrane,
\npresident of the American Finance Association, has recently
\nreferred to a \u201czoo\u201d of factors. We recently counted around
\n250 in published academic papers, and their number has
\nbeen increasing exponentially.<\/p>\n

\"cumulative_number_of_factors.jpg\"<\/p>\n

To avoid getting lost in the factor zoo\u2014so as not to be misled
\nby spurious correlations\u2014we think that there should be solid
\nempirical evidence for the existence of a factor and that there
\nshould also be some theoretical justification for its existence.<\/p>\n

LYXOR\u2019S FIVE-FACTOR FRAMEWORK<\/h2>\n

Lyxor\u2019s equity market factor framework focuses on
\nthose alternative risk premia that have solid theoretical
\nsupport and which are backed by empirical evidence. The
\nframework has five components: in addition to the Fama-
\nFrench factors of value and size we include momentum,
\nlow volatility and quality.<\/p>\n

\"risk_factor_solutions.jpg\"<\/p>\n

FACTOR APPROACHES WORK BEST REGIONALLY<\/h2>\n

Our research suggests that factor investment approaches work best in a regional context.<\/em><\/p>\n

Value Factor Returns by Region.<\/strong>
\n\"value_factor_returns_by_region.jpg\"<\/p>\n

Size Factor Returns by Region.<\/strong>
\n\"size_factor_returns_by_region.jpg\"<\/p>\n

Over the period between 1995 and 2013 value factor investing
\nproduced positive relative returns in the US, Europe, Japan
\nand Asia-Pacific, particularly in the period between the
\nmarket peaks of 2000 and 2008. But, relative to local largecap
\nstocks, small caps have done better in the US than in the
\nother three regions. These differences in factor returns across
\nregions probably reflect differences in market structure.<\/p>\n

THE EXPLANATORY POWER OF FACTORS VARIES<\/h2>\n

When compared to traditional market beta, the ability of
\nalternative factors like value and size to explain market returns
\nis not fixed. Our research suggests that the ability of individual
\nfactors to explain stock returns probably moves in a 5-10 year
\ncycle and, over time, reverts to the mean.<\/p>\n

And it\u2019s important to point out that the collective power of
\nfactors also varies. Since 2005, the combined impact of the
\nFama-French value and size factors on the US equity market
\nwas lower than in the 2000-2005 period, for example. Value
\nand size stocks moved very much in unison during the period
\nafter the dot-com bubble burst.<\/p>\n

These observations suggest that it makes sense to diversify
\nacross factors in a portfolio.<\/p>\n

It\u2019s important to point out that there is
\ndiversity a mongst factor a pproaches<\/quote><\/p>\n

THE VALUE FACTOR HAS TWO COMPONENTS<\/h2>\n

Within Lyxor\u2019s factor framework, two factors are similar in that
\nthey both focus on stocks that trade at a valuation discount to
\nthe market portfolio: quality and value.<\/p>\n

The quality factor highlights higher-quality, less cyclical, lowerleverage
\ncompanies with above-average yields: these are
\ndefensive stocks that are likely to underperform in a rising
\nmarket but which offer better protection in a downturn.<\/p>\n

Our value factor focuses on distressed stocks, which are
\nrelatively risky but which offer the potential of large price gains
\nin a recovery[[See Lyxor\u2019s Expert Opinion, \u201cBrave Value Investing\u201d.]]. Examples of stocks in this category are BP after
\nthe 2010 Deepwater Horizon oil spill or Tesco after the 2014
\ndisclosure that the company\u2019s earnings had been overstated.<\/p>\n

Soci\u00e9t\u00e9 G\u00e9n\u00e9rale calculates indices based on both these
\nfactor approaches, the SG Quality Income and the SG
\nValue Beta indices. In our view these strategies are highly
\ncomplementary for a portfolio investor.<\/p>\n

FACTOR STRATEGIES MUST TAKE INTO ACCOUNT
\nLIQUIDITY AND CAPACITY<\/h2>\n

Factor-based strategies are of interest to many types of
\ninvestor, including the very largest pension and sovereign
\nwealth funds.<\/p>\n

But the potential implementation costs of a smart beta
\nstrategy of any size are important, particularly for the largest
\ninvestors. Any investment portfolio that deviates from the
\nmarket capitalisation-weighted index will generate some
\nincremental costs as a result of additional turnover.<\/p>\n

Research by Frazzini and others, published in 2012, suggests
\nthat value is the factor with the greatest potential investment
\ncapacity, followed by size and momentum.<\/p>\n

It\u2019s important to point out that there is diversity amongst factor
\napproaches, something that may alleviate potential capacity
\nconstraints and concerns over crowding. For example the value factor indices published by the main index providers
\nhave subtle differences in their methodologies, so they don\u2019t
\nall hold the same stocks in the same proportions.<\/p>\n

ALLOCATING EQUALLY ACROSS FACTORS CAN GIVE POWERFUL RESULTS<\/h2>\n

One of the principal reasons for the rising interest in factor
\ninvesting is that diversifying across factors appears to give
\nmore powerful results than diversifying in the traditional way,
\nby asset class, because of the lower correlations we observe
\nbetween factors.<\/p>\n

But how much of a portfolio should we allocate to each factor?
\nWhen asset allocators consider how much of their portfolios
\nto devote to equities and bonds they usually start with quite
\ndistinct return and risk forecasts for these two asset classes,
\nleading to a variable equity\/bond allocation for investors with
\ndifferent risk appetites. This type of forecasting exercise,
\nwhich is not easy, is even more difficult for factor returns.<\/p>\n

In the table and chart below we show the return and risk
\ncharacteristics of five world factors and we compare them to
\nthe MSCI World Net Total Return Index. All the factor indices
\nproduce higher Sharpe ratios than the market portfolio, but
\nnote that the returns of the individual factor indices are within a
\nrange of just over 3% a year.<\/p>\n

Factors need to be used consciously and carefully, with full knowledge of their characteristics<\/p><\/blockquote>\n

\"10-year_risk-return_profiles_of_factor_indices.jpg\"
\n\"10-year_risk-return_profiles_of_factor_indices-2.jpg\"<\/p>\n

In fact a simple approach to factor allocation\u2014equalweighting\u2014
\nhas a lot of benefits. Our calculations show
\nthat for this period equal weighting produced better returns
\nthan other, more complex approaches to allocation, such
\nas equal risk contribution, volatility weighting or minimum
\nvariance.<\/p>\n

FACTORS SHOULD BE USED SENSIBLY<\/h2>\n

Factors can be a powerful tool to represent in a systematic
\nway how the equity market\u2019s returns are produced. They are
\nhaving a major impact on how investing and asset allocation
\nare done. But factors need to be used consciously and
\ncarefully, with full knowledge of their characteristics.<\/p>\n

MOVING FROM THEORY TO PRACTICE<\/h2>\n

Investors may feel lost when confronted with 250 risk
\nfactors. They are required not only to understand the
\ncharacteristics of each factor but also how to combine
\nthem in a portfolio. And to move from theory to practice,
\nfactor investing demands both technical expertise and
\nexperience. It\u2019s also natural to question whether factors
\nshould be used as part of a strategic allocation or to take
\nmore tactical investment positions.<\/p>\n

To help answer such questions, together with my co-author
\nZ\u00e9lia Cazalet I have recently written a paper entitled \u201cFacts
\nand Fantasies About Factor Investing\u201d. We take a holistic
\nview of risk factors, aiming to demonstrate certain factors\u2019
\npersistence and suggesting how to allocate between them
\nin portfolios.