Factor Investing Flashcards
What is factor investing?
FI targets specifc asset characteristics as sources of expected return.
Name some of the sources of expected return?
Within equity risk premium there might be value, momentum, low beta, size, quality.
Also credit risk premium, duration, illiquidity premia etc
How have investors historically looked at asset classes?
Investors have historically allocated capital mainly by asset class, gaining diversification through exposure to equity funds, bonds and money market instruments.
What are some negatives about focusing on factors?
Individual factors still have large periods of underperformance. Think of value’s most recent decade long underperformance versus growth.
What is the benefit of combining factors?
They have lower correlations which reduces portfolio risk.
What is beta?
an assets volatility versus a benchmark.
What is the low beta factor?
research suggests that high beta assets do not produce meaningfully higher returns than low beta assets.
What does low beta factor suggest on a risk adjusted basis?
Risk adjusted returns for a low beta portfolio are significantly higher (hence outperform) a high beta poertfolio.
This leads to a higher sharpe ratio.
What quantitative strategies use factors as building blocks?
Smart beta and long short funds.
How can factor correlations help in constructing a portfolio?
The dream is to have factors that have low correlations to each other, which provides more balanced and diversifications than otherwise.
An eg is momentum which has a low correlation to value, size and low volatility.
Name certain things that are raised to question factor efficacy? or at least highlight the risks?
Value has had two 11 year bear markets.
Momentum has a great returns track record but has high trading costs that can devour alpha.
A factor can underperform for a while which might be difficult for the investor to handle.
Factors can have periods of serial correlation meaning that bad periods of performance can be followed by further periods of bad performance.
Some factors might have an illusion of value add which dont necessarily have structural efficacy.
Also returns might be arbitrateged away over time.
In a 1963-2017 study of US factor performance, what was the result of combining 6 factors in a portfolio (value, momentum, low beta, size, quality and profitability)?
520bp excess return pa with a 60% improvement in the sharpe ratio (0.8 v 0.48) with the same annualized volatility -15.3%.
How can scenario analysis be used with Factor analysis?
You can run various scenarios like stagflation, inflation, EM slow down, productivity boom and see how factors would have performed and also look at their correlations.
What is the size factor?
Research has shown that smaller market cap stocks tend to outperform large ones.
Hence this is refered to as the size premium.
What does the quality factor say?
Companies that exhibit higher quality (low investment, strong moats, higher profit margins, higher returns) outperform lower quality companies.
