Factor investing is a recent development in the area of asset allocation and portfolio design. The groundwork for factor returns was set in 1992, when Eugene Fama & Kenneth French demonstrated the existence of two factors, “value” and “size”, which historically have been significant drivers of equity market performance. However, only in recent years have these ideas been synthesized and presented in practical form by the investment industry. One of the central concepts in finance is that returns above the risk-free rate are compensation for exposure to risks.
How Risk Factors Are Described?
A risk factor represents a unique source of risk and risk premium in financial markets such that the observed risk and risk premium cannot be fully explained by other risk factors. In other words, risk factors are not supposed to be highly correlated with each other. In addition, risk factors should have a sound economic foundation, with rigorous academic and industry research supporting their presence. Finally, risk factors must show that their risk premiums are persistent over long periods.
The capital asset pricing model (CAPM) can be thought of as the first theory of risk factors. According to the CAPM, the expected excess return on a risky asset is equal to the beta of the asset times the risk premium on the market portfolio.
The ex-post capital asset pricing model (CAPM) returns can be explained as:
Factor-based investing dives deeper into what was previously understood to be alpha, identifying common risk factors, which tend to drive the returns of individual securities. A factor-based analysis decomposes what was hitherto considered “alpha” into returns driven by common risk factors and a residual component which represents “true alpha.”
Today, it is widely accepted that equity portfolio returns are better expressed as:
Following is a partial list of the best-known risk factors:
Value premium: Based on the return earned by stocks with high book values relative to their market values. The strategy is to take long positions in stocks with a relatively high ratio and short positions in stocks with a relatively low ratio.
Size premium: Based on the rate of return earned by small-cap stocks. The strategy is to take long positions in small-cap stocks and short positions in large-cap stocks.
Momentum premium: Based on past performance of stocks. The strategy is to take long positions in past winners and short positions in past losers.
liquidity premium: Based on the risk premium earned by illiquid assets. The strategy is to take long positions in illiquid assets and short positions in similar but otherwise liquid assets.
Credit risk premium: Based on the credit risk of bonds. The strategy is to take long positions in bonds with low credit quality and short positions in bonds with high credit quality.
Term premium: Based on the riskiness of long-term bonds. The strategy is to take long positions in long-term bonds and short positions in short-term bonds.
Implied volatility premium: Based on the risk premium earned by the volatility factor. The strategy is to be short the implied volatility of options (e.g., create a market-neutral position using short positions in out-of-the-money puts and short positions in stocks).
Low volatility premium: Based on the return to low volatility stocks. The strategy is to take long positions in low volatility stocks and short positions in high volatility stocks. The same strategy can be implemented using betas.
Carry trade: Based on the return to investments in high-interest-rate currencies. The strategy is to take long positions in bonds denominated in currencies with high interest rates and short positions in bonds denominated in currencies with low interest rates.
Roll premium: Based on the return earned on commodities that are in backwardation. The strategy is to take long positions in commodities that are in backwardation and short positions in commodities that are in contango.
Are all risk factors investable?
While 20 years ago it might have been difficult and costly to create investment strategies that represented various risk factors, financial innovations of the past two decades have substantially reduced the cost of such strategies.
For example, in recent years, exchange-traded funds (ETFs) have become available that track value, volatility, momentum, size, and roll factors. These strategies are often described as using smart beta. Another term for describing the investability of a risk factor is that it is tradable.
The primary benefit of factor investing is that it informs investors that returns will come from being exposed to certain risk factors and allows asset owners to decide if earning returns through exposure to these certain risk factors is consistent with their objectives and constraints.