Factor investing is by no means a new concept, but has gained some serious steam in recent years as investors look for new ways to distribute capital. Quantitative strategies offer a new approach to capital allocation, allowing for improved diversification over existing models.
Investors have historically allocated capital mainly by asset class, gaining diversification through exposure to equity funds, bonds and money market instruments.
One problem with this approach is that in times of market weakness, different asset classes can re-correlate, thereby nullifying the diversification benefits of allocating capital through an asset-class approach.
According to a paper by the Reserve Bank of Australia, the correlations between stock and bond yields turned positive in the late 1990s and the two asset classes have been highly correlated since – particularly so in the wake of the global financial crisis.
This has been attributed to the development of the ‘risk-on, risk-off’ pattern across world markets as uncertainty abounds.
More investors are turning to the underlying performance drivers inherent in many assets, and are allocating capital along factor lines rather than by asset class.
Common equity factors include value (undervalued stocks tend to outperform expensive ones), low volatility and small size, among a growing number of other identified stock drivers. These risk factors each carry a risk premium, which explains their above-normal rates of return.
Factors provide the building blocks for quantitative strategies like smart beta indices and long-short risk premia funds.
Institutional investors around the world are harvesting the benefits of risk premia, by either complementing their hedge funds or substituting their more expensive hedge fund exposure with risk premia.
By constructing a portfolio that includes exposure to multiple factors, many of which have low correlations to one another, investors aim to have more balanced and diversified funds than would otherwise be the case.
For example, the momentum factor (stocks with momentum tend to maintain a positive trajectory) often has low correlations to other factors including value, size and low volatility. The momentum factor tends to perform at different times to these other factors, meaning its diversification potential is strong. Additionally, the momentum factor tends to have a relatively high risk premium.
These factors are sometimes uncorrelated in both long-only and in long-short funds (momentum and value, for example), meaning that their diversification benefits can be reaped by both smart beta and risk premia strategies.
In short, a healthy balance between the major risk factors is necessary for an overall portfolio to be meaningfully diversified.
And these factors are becoming more widely available for exploitation, thanks to the rise of smart beta and risk premia products.
How smart beta and risk premia strategies apply the factor approach
Long-only smart beta strategies build indices that have a tilt to one or more factors. These funds, sometimes called custom indices, can either reweight standard benchmark indices or construct new indices from scratch.
For example, a smart beta strategy could involve assigning alternative weightings to the constituents of the S&P 500 benchmark index, in order to reduce the bias towards large stocks and offer a tilt towards low-volatility shares.
On the other hand, an index could be assembled from scratch after identifying a basket of value stocks and investing in those which meet the strategy’s rules and criteria. This requires analyses and decision making and means smart beta applies active fund management to passive investing.
Smart beta strategies hold only long positions in these indices, targeting relative returns over the benchmark portfolio.
Risk premia strategies, meanwhile, use corresponding short positions in order to generate absolute – rather than relative – returns. While smart beta strategies are usually highly correlated to equity markets (in financial terms, they have high ‘beta’ exposure), risk premia strategies can strip out the beta element.
By banking on the outperformance of a smart beta index, for instance, a risk premia fund can take a long position in the index while short selling the benchmark. The net difference between the two essentially allows the investor to profit from market inefficiencies or abnormalities.
Risk premia strategies can be far more complex than this example, using leverage and derivatives to amplify returns.
Alternative premia strategies can be packaged in a number of different formats, each with different mechanisms to extract the benefits that factors offer.