By |Published On: July 10th, 2017|Categories: Basilico and Johnsen, Academic Research Insight|
  • Title: FACTS ABOUT FACTORS
  • Authors:        PAULA COCOMA, MEGAN CZASONIS, MARK KRITZMAN, DAVID TURKINGTON
  • 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.

The Most Important Chart from the Paper:

Print Friendly, PDF & Email

About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

—

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

Join thousands of other readers and subscribe to our blog.

Print Friendly, PDF & Email