Shortcuts to Factor Investing: Multifactor Portfolios and Benchmarking

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As various investing fashions like energetic administration wrestle, the issue investing method offers a refreshing various, selecting out underlying drivers of funding returns equivalent to inflation, rates of interest, or GDP development.

A multifactor method combines these recognized drivers into an optimum portfolio to higher fulfill investor aims utilizing macroeconomic, fundamental, and statistical factor models.

The first article on this collection described the mental historical past of issue investing. The second took a deeper dive into completely different issue investing approaches for shares and wider functions to different asset courses together with mounted revenue. Here, we have a look at combining components in multifactor portfolios and contemplate problems with efficiency measurement in issue investing.

More than 50 years after its introduction, probably the most highly effective idea in forming investing portfolios stays conventional imply variance optimization (MVO) based mostly on quadratic ideas in modern portfolio theory (MPT) — which follows the favored instinct of not placing all of your eggs in a single basket.

MPT has weathered any variety of makes an attempt to overturn it, such because the seemingly insightful however considerably impractical prospect concept and behavioral finance, an educational area depending on elegant however questionable fashions and hard-to-replicate experiments. In distinction, multifactor investing retains the sturdy and acquainted framework of MPT however with completely different inputs.

With their underlying widespread exposures, sure underpinning asset courses will be readily remixed to enhance portfolio diversification, in accordance to Eugene L. Podkaminer, CFA,  in “Risk Factors as Building Blocks for Portfolio Diversification: The Chemistry of Asset Allocation.” Citing widespread and overlapping threat exposures equivalent to forex, volatility, and inflation, Podkaminer exhibits how correlations amongst asset courses will be excessive, detracting from diversification.

But implementing issue investing stays a problem. No single alternative set, such because the market portfolio, encompasses all of the components. Weighting components will also be difficult, with many researchers and practitioners utilizing the shortcut of an equal weighting approach. An particular person inventory can overlap a number of various factors main to complicated interplay results. Such components as momentum or GDP development might not be simply investable. Correlations, similar to previous and future issue threat premia, will be fast-moving targets and necessitate frequent re-balancing. Use of the lengthy and brief exposures obligatory to implement some components could also be disallowed for sure buyers.

One survey summarized in CFA Digest finds points and challenges in key phases of the decision-making and implementation technique of issue investing. Yet, the potential for sensible functions is substantial sufficient to recommend that curiosity within the space is probably going to endure. Some potential advantages embrace:

  • Better analysis of a portfolio throughout the varied macroeconomic eventualities utilizing the issue lens.
  • De-risking liability-driven investing (LDI) portfolios on each the asset and legal responsibility sides.
  • Use of things inside and throughout supervisor constructions to determine cross-correlations.

A brand new monograph by a staff of researchers at PIMCO, Factor Investing and Asset Allocation: A Business Cycle Perspective, means that real-life portfolio allocation issues will be higher solved by adopting a broad reasonably than slender vary of fashions and working with easier fashions.

Performance Measurement and Factor Investing

New investing methods demand rigorous standards to measure and attribute their success or failure. In his well timed article, Andrew Lo asks the existential query, “What Is an Index?” Lo finds that dynamic indices, equivalent to a volatility-controlled index, not tied to market-cap weights have many benefits when it comes to assembly investor aims, however additionally they require higher sophistication to consider and keep away from unintended penalties.

Factor evaluation can be utilized to assess whether or not a supervisor is reaching alpha or utilizing a factor-based technique to seize returns from beta says Deborah Kidd, CFA, in “Factor Investing: When Alpha Becomes Beta.” The benchmarking efficiency of issue investing appears to provide many challenges since direct comparisons with available indices will not be all the time helpful.

Many finish buyers revert to oversimplified comparisons of particular person issue efficiency with T-bill charges or long-run (market-cap weighted and long-only) fairness or bond returns. These are unsatisfactory pairings, particularly since fairness and bonds have proven such excessive current correlation. Peer group comparisons throughout components are additionally tough, particularly as soon as leverage, charges, and prices — which aren’t equal throughout components and methods — are considered. Nevertheless, it might be odd if the identical skepticism about energetic administration that drove investor flows into issue investing was suspended for underperforming components.

Ultimately, buyers must be forecasting as a lot (ex ante) as they’re trying backward (ex publish) at issue efficiency of their portfolios. To try this successfully, a greater understanding of the chosen items of threat and the project of extra considerate benchmarks on the outset ought to assist buyers acquire extra return at decrease threat.

A full topical assortment of really helpful hyperlinks for all of the associated materials on issue investing coated on this collection will be discovered beneath together with a Glossary.

Glossary

Factor Investing: Applies to a variety of risk-based approaches that sit between energetic and passive funding administration however possess attributes of each. Uses each lengthy and brief methods.

Smart Beta: A advertising label describing easy, rules-based, and clear approaches to constructing portfolios that ship pretty static exposures (relative to capitalization-weighted benchmarks) to traits traditionally related to extra risk-adjusted returns. Often lengthy solely.

Alternative Beta: A subset of  “smart beta,” various beta is distinguished from sensible beta by its use of brief in addition to lengthy investing.

Fundamental Indexation: Another subset of “smart beta” with a deal with utilizing accounting, financial, and weighting knowledge to develop new indices.

Topical Reading Collection

1. What Is Factor Investing?

Count on Low Expected Returns, Says Antti Ilmanen

“I have got bad news as a starter,” Antti Ilmanen informed the viewers on the 2016 CFA Institute European Investment Conference. “It is not only a low interest rate world, it is also a low expected return world on any long-only investment.” Ilmanen, a principal and researcher at hedge fund AQR, stated low anticipated returns are going to anchor dangerous information for all of us for the remainder of our working lifetimes. And perhaps past.

The Asset Manager’s Dilemma: How Smart Beta Is Disrupting the Investment Management Industry

Smart beta merchandise are a disruptive monetary innovation with the potential to considerably have an effect on the enterprise of conventional energetic administration. Ronald N. Kahn and Michael Lemmon present an vital part of energetic administration by way of easy, clear, rules-based portfolios delivered at decrease charges.

Quantitative Investing Is Fundamental

The quant supervisor has the identical set of instruments that any energetic supervisor has: Quants merely apply them utilizing the ever-increasing energy of computer systems, Gina Marie N. Moore, CFA, observes. These instruments permit the supervisor to pursue reward and cope with threat, prices, charges, and shopping for themselves the time obligatory to distinguish funding talent from luck.

Fundamentals of Efficient Factor Investing

Combining long-only constrained issue subportfolios is usually not a imply variance environment friendly means to seize anticipated issue returns, Roger G. ClarkeHarindra de Silva, CFA, and Steven R. Thorley, CFA, observe. For instance, a mix of 4 totally invested issue subportfolios — low beta, small dimension, worth, and momentum — captures lower than half (e.g., 40%) of the potential enchancment over the market portfolio’s Sharpe ratio. In distinction, a long-only portfolio of particular person securities, utilizing the identical threat mannequin and return forecasts, captures most (e.g., 80%) of the potential enchancment.

2. Industry Scope and Challenges to Factor Investing

The Rise of Institutional Investors, from Financial Market History: Reflections on the Past for Investors Today 

Since the start of the 20th century, institutional buyers have gained prominence within the UK and US monetary markets not solely due to adjustments in financial entry but additionally due to adjustments in the best way governments shield buyers, in accordance to Janette Rutterford and Leslie Hannah.

Does Academic Research Destroy Stock Return Predictability?

Financial analysis has uncovered many new components (small cap, worth, momentum, low beta) that specify inventory returns. In reality, many of those components have already been commercialized into monetary merchandise. The authors look at whether or not these historic insights and return patterns stay after the educational analysis discovering them is printed.

Backtesting

Because of the potential for knowledge mining and a number of testing, it is not uncommon observe to haircut reported Sharpe ratios by 50% when evaluating backtests of buying and selling methods. Campbell R. Harvey and Yan Liu suggest an method that calculates a haircut to the Sharpe ratio to account for knowledge mining and a number of testing.

Smart Beta Is Not Monkey Business

Exchange-traded funds (ETFs) have been rising in recognition with current developments in factor-tilted methods. Some buyers have noticed that these portfolios derive most of their outperformance from publicity to solely two components — worth and small dimension — and the portfolios outperform even when randomly put collectively or turned the wrong way up (monkey portfolios), in accordance to Noël AmencFelix Goltz, and Ashish Lodh.

Robustness of Smart Beta Strategies

Investors are cautious of the robustness of the outperformance of sensible beta methods. Noël AmencFelix GoltzSivagaminathan Sivasubramanian, and Ashish Lodh deal with this concern by offering measures of relative and absolute robustness. They look at the causes of an absence of robustness and suggest treatments for these issues. Their conclusions deal with the risks of information mining and an absence of transparency.

Will Your Factor Deliver? An Examination of Factor Robustness and Implementation Costs

The multifactor investing framework has turn into extremely popular within the indexing group. Both educational and practitioner researchers have documented a whole lot of fairness components. But which of those components are seemingly to revenue buyers as soon as carried out? Noah BeckJason HsuVitali Kalesnik, and Helge Kostka discover that lots of the documented components lack robustness.

3. Equities Factor Investing

A Five-Factor Asset Pricing Model

Eugene Fama and Kenneth French introduce a five-factor asset pricing mannequin that outperforms the well-known Fama–French three-factor asset pricing mannequin in explaining inventory returns. Surprisingly, when the 2 extra components of profitability and funding are added to the unique three-factor mannequin, the worth issue turns into superfluous. Although the five-factor mannequin will not be with out its challenges, it’s helpful in describing the cross-sectional variance of the components’ anticipated return.

Dissecting Anomalies with a Five-Factor Model

By including profitability and funding components to their earlier three-factor mannequin, Eugene Fama and Kenneth French clarify the market β, web share points, and volatility anomalies. The accruals and momentum anomalies can’t be defined by the five-factor mannequin.

Return of the Quants: Risk-Based Investing

Managed volatility and coated name writing are two of the few systematic funding methods which were proven to carry out properly throughout quite a lot of empirical research and in observe. So far, they’ve been studied principally as separate methods. It seems that when mixed, these two methods create a robust toolset for portfolio enhancements, in accordance to Anna Dreyer, CFA, Robert L. Harlow, CFA, Stefan Hubrich, CFA, and Sébastien Page, CFA.

Fact, Fiction, and Value Investing

The concept that seemingly low cost securities, in accordance to measures of elementary and intrinsic worth, outperform seemingly costly securities has been scrutinized by teachers for greater than 30 years, but the worth technique continues to be extensively misunderstood. Recent analysis that up to date the extensively cited Fama–French three-factor mannequin launched two new components that declare to make the worth issue redundant. Clifford Asness, Andrea Frazzini, Ronen Israel, and Tobias Moskowitz determine a variety of information and fictions about worth investing that want clarification.

Facts about Formulaic Value Investing

The time period “value investing” is more and more being adopted by quantitative funding methods that use ratios of widespread elementary metrics (ebook worth, earnings) to market value. A trademark of such methods is that they don’t contain a complete effort to decide the intrinsic worth of the underlying securities. We argue that these methods shouldn’t be confused with worth methods that use a complete method in figuring out the intrinsic worth of the underlying securities.

Chapter 14: Factor Investing

In issue investing, property are considered as bundles of underlying threat components, in accordance to Andrew Ang. Investors ought to maintain components whose losses they will endure extra simply than the standard investor can. Ideally, the benchmark for issue investing is dynamically based mostly on investor-specific circumstances reasonably than on market capitalization.

4. Bond Factor Investing

Factor Approach to Fixed-Income Allocation

A threat issue–based mostly method can be utilized for managing fixed-income portfolios. Ramu Thiagarajan, Douglas J. Peebles, Sonam Leki Dorji, Jiho Han, and Chris Wilson present {that a} restricted set of things — fee, development, and volatility — clarify the return on fixed-income portfolios. Investors can use this method in managing and analyzing their portfolios and in incorporating their macro views into their asset allocation choices.

Fundamental Indexing in Global Bond Markets: The Risk Exposure Explains It All (In Practice Summary

To examine the basic indexing methodology, Lidia Bolla, CFA, applies it to international authorities bond markets and examines its publicity to a number of newly launched threat components. She finds that the basic indexing method outperforms a market-value-weighted index. However, her outcomes present statistically important and economically related exposures of basically weighted indexes to the danger components time period and length threat, default threat, convexity threat, liquidity threat, and carry commerce threat. The elevated threat publicity explains the outperformance of the basic indexing methodology in authorities bond markets.

Shedding Light on Fixed-Income Performance Attribution

Fixed-income attribution explains the sources of a supervisor’s energetic return, Deborah Kidd, CFA, observes. A posh course of, attribution will be difficult to implement and typically affected by massive, unexplained residual returns. Understanding the assumptions underlying a supervisor’s attribution mannequin and their relation to the funding course of, together with a qualitative evaluation, will help decide how properly the attribution displays the supervisor’s decision-making expertise and present a clearer image of efficiency.

5. Other Asset Classes

Factor Investing in the Corporate Bond Market

Patrick Houweling and Jeroen van Zundert, CFA, provide empirical proof that dimension, low-risk, worth, and momentum issue portfolios generate economically significant and statistically important alphas within the company bond market. Because the correlations between the single-factor portfolios are low, a mixed multi-factor portfolio advantages from diversification among the many components: It has a decrease monitoring error and a better info ratio than the person components.

Understanding the Risks in Alternative Beta Indices

The variety of alternatively weighted fairness indices, additionally referred to as “alternative beta indices,” has risen dramatically since their introduction into the index scene within the mid-2000s. Deborah Kidd, CFA, offers an summary of common alternatively weighted index schemes and offers buyers a framework with which to perceive and gauge the suitability of an alternate index for his or her desired threat exposures.

Two Centuries of Price-Return Momentum

Having created a month-to-month dataset of US safety costs between 1801 and 1926, Christopher C. Geczy and Mikhail Samonov conduct out-of-sample assessments of price-return momentum methods which were carried out within the post-1925 datasets. The extra time-series knowledge strengthen the proof that value momentum is dynamically uncovered to market threat, conditional on the signal and length of the trailing market state.

The Low-Volatility Anomaly: Market Evidence on Systematic Risk vs. Mispricing

Xi Li, Rodney N. Sullivan, CFA, and Luis Garcia-Feijóo, CFA, CIPM, discover whether or not the well-publicized anomalous returns related to low-volatility shares will be attributed to market mispricing or to compensation for larger systematic issue threat. The outcomes of their research, protecting a 46-year interval, point out that the comparatively excessive returns of low-volatility portfolios can’t be considered solely as compensation for systematic issue threat.

Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios

Research displaying that the lowest-risk shares have a tendency to outperform the highest-risk shares over time has led to speedy development in so-called low-risk fairness investing lately. Luis Garcia-Feijóo, CFA, CIPM, Lawrence Kochard, CFA, Rodney N. Sullivan, CFA, and Peng Wang, CFA, look at the efficiency of each the low-risk technique beforehand thought of within the literature and a beta-neutral low-risk technique that’s extra related in observe.

6. Multi-Factor Approaches

Chapter 11. An Introduction to Multifactor Models

After finishing this chapter of Quantitative Investment Analysis, Third Edition, readers will probably be in a position to describe arbitrage pricing concept (APT), together with its underlying assumptions and its relation to multifactor fashions; outline arbitrage alternative and decide whether or not an arbitrage alternative exists; calculate the anticipated return on an asset given an asset’s issue sensitivities and the issue threat premiums; and extra.

Risk Factors as Building Blocks for Portfolio Diversification: The Chemistry of Asset Allocation

Asset courses will be damaged down into components that specify threat, return, and correlation traits higher than conventional approaches.

Factor Investing and Asset Allocation: A Business Cycle Perspective

This monograph, by Vasant NaikMukundan DevarajanAndrew NowobilskiSébastien Page, CFA, and Niels Pedersen, attracts closely on the huge physique of data that has been constructed by monetary economists during the last 50 years. Its aim is to present how to resolve actual‐life portfolio allocation issues. The authors have discovered that utilizing a broad vary of fashions works finest and desire easy over complicated fashions.

Asset Allocation with Macroeconomic Foundations: The Risk Factor Approach (A Summary)

Diversification in portfolios is fascinating, however the fashions we use to obtain this goal could also be deceptive as a result of they’re divorced from macroeconomics. Individual and institutional buyers ought to pay shut attention to enhancements to the standard method to asset allocation, together with consideration of forward-looking macro views.

Practical Considerations for Factor-Based Asset Allocation

Despite the shortcomings of conventional asset allocation insurance policies, most funding portfolios are nonetheless constructed based mostly on direct asset class publicity. In addition, it might not be possible for buyers to implement policy-level choices utilizing a factor-based allocation framework. Daniel Ung, CFA, and Xiaowei Kang, CFA, talk about three approaches to threat issue–based mostly portfolio building and provide their reflections on the sensible facets of implementation.

7. Performance Measurement of Factor Investing

What Is an Index?

The current advances in computational and monetary expertise and resultant monetary innovation have created the opportunity of a brand new perspective on indexes, indexation, and the excellence between energetic and passive investing, writes Andrew Lo.

Factor Investing: When Alpha Becomes Beta

Many sources of alpha have turn into simple to determine and extensively replicated over time, Deborah Kidd, CFA, notes. Such systematic return drivers, or components, occupy the area between conventional beta and alpha. They symbolize funding methods that require talent past passive investing however not the complexity obligatory for alpha era

Does It Pay to Bet Against Beta? On the Conditional Performance of the Beta Anomaly

In trying to revenue from the anomaly that the noticed returns for high-beta shares inadequately compensate for his or her larger publicity to market threat, practitioners have more and more “bet against beta” — promoting brief high-beta property and shopping for low-beta property. Scott Cederburg, CFA, and Michael S. O’Doherty problem the existence of any such anomaly.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

Image credit score: ©Getty Images/erhui1979

Mark Harrison, CFA

Mark Harrison, CFA, is director of journal publications at CFA Institute, the place he helps a set of member publications, together with the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has greater than 12 years of funding expertise as a portfolio supervisor and securities analyst. Harrison is a graduate of the University of Oxford.

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