Primer: the Factor Drivers of Investment Returns

Primer: the factor drivers of investment returns April 2017 For Financial Intermediary, Institutional and Consultant use only. Not for redistribution under any circumstances. Primer: the factor drivers of investment returns 2 Primer: the factor drivers of investment returns Many of the concepts behind factor investing are nearly as old as investing itself. Much newer is the idea of bringing them together systematically. This is transforming the way investors think of portfolio construction, and the reasons are clear: factor investing offers diversification, transparency and economy. We review the underlying concepts and show how they underpin a number of apparently disparate developments from smart beta to alternative risk premia. Factor investing provides important new Ashley Lester, tools for the investor, but, like all tools, having a firm understanding of Ph.D. Head of their purpose remains critical to results. Research, Multi-Asset Why factor investing? The aim here is to achieve more stable diversification than asset class allocation alone. Traditionally, investors have thought of the The risk premia underlying assets may have world in terms of asset classes, such as equities a more stable relationship than that between and bonds. Factor investing looks beneath asset asset classes, since the mix of risks and expected classes to allocate according to the factors that returns in an asset class can vary. In October drive risk and return. Some of these so-called ‘risk 2008, for instance, corporate bond risks and premia’ may correspond more or less directly to expected returns were dominated by credit risk, an asset class, such as the equity risk premium. while by 2016 long-term interest rates (duration) Other asset classes represent a combination of were more important (Figure 1). These variations factors. For instance, corporate bonds combine affect the risk, return and diversification of long-term interest rate risk (itself divisible into portfolios considerably. Factor investing seeks inflation and duration risk) and credit risk, and more direct exposure to the drivers of return, these two sources of risk are separable, at least in which have shown more stable relationships principle1. with each other and therefore more consistent diversification. Figure 1: Dissecting corporate bonds into their risk premia % US investment grade credit 10 8 6 4 2 0 31 October 2008 29 July 2016 Risk-free rate Credit risk premium Duration risk premium Source: Schroders. For illustrative purposes only. Does not reflect any actual portfolio. For instance, by hedging out the duration risk, or investing in credit default swaps. For more on this subject, see “Putting a premium on risk”, Investment Horizons, issue 1, 2014. For Financial Intermediary, Institutional and 3 Primer: the factor drivers of investment returns Consultant use only. Not for redistribution under any circumstances. What are the factors? hold them. If one investor holds a value strategy, all the other equity investors in the world must be The factors we have discussed so far are traditional collectively underweight value, relative to the market. elements of portfolios. But much of the recent So here is our first note of caution: if factors are well excitement comes from less traditional factors, which known, either they may not continue to outperform, are increasingly used as portfolio building blocks. The or there must be another reason why some choose best known are equity strategies such as value, size, not to use them. quality, low volatility and momentum. These sorts of ‘dynamic’ factors, widely marketed as ‘smart beta’, At their most basic, factors are rule-based strategies require active management to maintain exposure, as that can generate outperformance over lengthy a stock that was good value last month, for example, periods. A more helpful way to analyze them is to may be overpriced this month. These differ from look at how the basic rule can be turned into different traditional factors in another way: not everyone can strategies of varying sophistication and risks (Figure 2). Figure 2: The evolution of factor portfolios, from smart beta to alternative risk premia Long-only Long-short Starting universe Rank by factor “smart beta” “alternative risk premia” Cheap Marke t Expensive Cheap Cheap Long Long Short Short Expensive Source: Schroders. For illustrative purposes only. Does not reflect any actual portfolio. Suppose we have a rule that ranks the desirability of Hence our second cautionary note about factor stocks and then use it to build a portfolio: we have investing: since all known factors experience periods created a form of ‘smart beta’. The term derives from the of underperformance, seeking a diversified portfolio of idea that we have captured something systematic about factor exposures is a much better idea than focusing on stock returns over and above general market moves. just one or two. ‘Alpha’, by contrast, is taken to represent above-market returns deriving purely from stock selection. Bringing these arguments together, we can say that factor investing aims to: A key point about this portfolio is that the single largest — enhance investment returns through historically driver of its returns is still the broad equity market as a demonstrated systematic strategies, whole. We hope that our rule tilts the risk and return of the portfolio in our favor, but if equity markets fall, for — improve diversification by breaking down risk into its example, our portfolio will also tend to fall. If we are a bit underlying components, and more sophisticated, and use our factor not only to buy — reduce fees, since strategies can be implemented the desirable stocks, but to short the undesirable stocks, more efficiently. we have entered the world of long-short equity hedge funds or, more generically, of ‘alternative risk premia’. Of course, building a portfolio that includes shorts is While the concept and intentions are straightforward, operationally more difficult than building a long-only the execution is not quite so simple. portfolio. And if the factor underperforms, the portfolio will not merely underperform the market, but actually lose money. Primer: the factor drivers of investment returns 4 Which factors? the University of Chicago3). In time, a new taxonomy may well emerge, but there is no particular reason to expect One of the canons of practical finance is that there are that it will resemble the remarkable simplicity of the four or five fundamental factors, discovered in stock model Fama and French propounded almost a quarter of markets, that can be applied equally well in other a century ago. markets, such as those for bonds and currencies. These It is no accident that equities have been a hotbed for factors are value, momentum, low volatility, and often new factors. Research is facilitated by freely available size or quality. Conventional wisdom is, however, wrong data, relatively straightforward return modeling and in two important ways. First, there are many more than highly dispersed returns from many different stocks, four or five plausible factors. Second, factor investing is allowing for the empirical examination of many different just as relevant to other asset classes as to equities, but factor ideas. Achieving the same results for government often involves quite different factors. bonds, commodities, currencies or, indeed, any other The notion that there are just four or five simply- asset class is much harder. Few should be surprised, described equity factors reflects the seminal findings of therefore, that nothing like 300 factors able to generate Eugene Fama and Kenneth French, then of the University outperformance have been found anywhere beyond of Chicago, starting in the early 1990s. In a series of equities. 1 research articles , Fama and French showed that the Nevertheless, systematic strategies have been returns from many different equity portfolios could be established across all asset classes. One type of factor mostly explained using returns from the market, along that is common across many is ‘carry’ – roughly speaking, with size and value. This was a major development in the amount an investor is paid to hold an asset, finance, as the significance of size and value shredded independently of price changes. This idea was originally the previous academic view that market returns were the applied to currency investing, where carry corresponds only systematically important and consistently rewarded to a given currency’s short-term interest rate. In equities, risk in equity markets. (This was the basis of the famous dividend yield is often identified as ‘carry’. Similarly, capital asset pricing model developed in the early to mid momentum – the idea that recent winners go on winning 2 1960s.) – seems to be an empirical regularity across many asset Fama and French influenced a generation of students classes and geographies. Other types of factors seem and practitioners, and their work laid the foundation asset-class specific – for example, roll-down is the profit for some of the most successful strategies of from holding a bond if an upward sloping yield curve recent decades. But the students they influenced remains fixed. understandably were not content with accepting that The existence of factors across many asset classes is two academics had discovered every conceivably important because it increases the possible opportunities important factor in equity markets. Their search for for factor investing. And because of the low historical additional factors was spectacularly successful. Over 300 correlation between factors across asset classes, a different equity ‘factors’ have now been identified in the multi-asset approach to factor investing should provide academic literature, with around one new factor having investors with greater opportunities for diversification been discovered each month on average over the past benefits than focusing solely on equities. 10 years. The academic quest now is to bring order to the ‘factor zoo’ (a term coined by John Cochrane, also formerly of Are factors generic? company’s assets to its market value.

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