Academic Research Insight: Facts about Factors

/Academic Research Insight: Facts about Factors

Academic Research Insight: Facts about Factors

By | 2017-08-18T17:11:00+00:00 July 10th, 2017|Basilico, Academic Research Insight|2 Comments
  • Publication: THE JOURNAL OF PORTFOLIO MANAGEMENT, SPRING 2017  (version here)

What are the research questions?

  1. Do factors offer superior diversification benefits relative to assets because factors are less correlated with each other?
  2. Does consolidating a larger set of assets into a smaller set of factors reduce noise?
  3. Are investors more skilled at relating current information to future factor behavior than to future asset behavior?
  4. Are factors and assets prone to the same types of errors that contribute to covariance instability?
  5. In summary, is it correct to use factors as building blocks for forming portfolios?

What are the Academic Insights?

  1. NO-this claim is only true because factors include short exposure to the assets.
  2. NO-The authors find no evidence that factor groupings reduce noise more effectively than asset class groupings. In fact, they find the opposite.
  3. NO-Investors who favor predicting factors face the additional challenge of mapping these factor predictions onto asset predictions, and they must also incur incremental trading costs to the extent that factor-mimicking portfolios change over time.
  4. YES-Factors are less stable than assets mainly because, unlike assets, they are subject to mapping error.
  5. NO-Investors should not replace assets with factors as the building blocks for forming portfolios.

Why does it matter?

While the authors acknowledge that factors may offer risk premia, which are an important component to portfolio’s returns, they advise against using factors instead of asset classes when defying the asset allocation of a portfolio. In fact, after reviewing a series of claims that back this idea in the scientific community, they find no strong evidence that it adds value compared to traditional asset allocation approaches.

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About the Author:

Elisabetta Basilico, PhD, CFA
Dr. Elisabetta Basilico is a seasoned investment professional with an expertise in "turning academic insights into investment strategies." Research is her life's work and by combing her scientific grounding in quantitative investment management with a pragmatic approach to business challenges, she’s helped several institutional investor achieve stable returns from their global wealth portfolios. Her experise spans from asset allocation to active quantitative investment strategies. Holder of the Charter Financial Analyst since 2007 and a PhD from the University of St. Gallen in Switzerland, she has experience in teaching and research at various international universities and co-author of articles published in peer-reviewed journals. She and co-author Tommi Johnsen are currently writing a book on research backed investment ideas. You can find additional information at Academic Insights on Investing.
  • Noel Dunivant

    This seems like an important challenge to factor-based investing. However, iIt doesn’t seem to me that the critique and recommendations can be correct, unless asset classes show the same kind of outperformance over the long run that factors do. What am I missing?

  • Elisabetta

    Thanks for your comment Noel. The authors critique some fallacies of the argument “to use factors instead of asset classes in asset allocation” : 1) factors are less correlated to each other compared to the assets; 2) reducing the dimensionality of assets into a small set of factors reduces noise; 3) factor behavior can be predicted more easily than assets; 4) risk properties of factors are more stable. They show that these arguments don’t seem to hold. The authors don’t question the risk premia. In fact, they aknowledge that factors have other important roles in portfolios.