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Assessing smart beta risk factor performance

by Vincent Denoiseux on Apr 04, 2014 at 12:40

Assessing smart beta risk factor performance

The smart beta trend is encouraging investors to look to create or access portfolios of risk factors. Below we look at the performance of different risk factors over time.

A number of products tagged as being smart beta offerings have recently come to market. Of these, several offer access to what are termed ‘risk factors’ or ‘risk premia’, such as value, quality, and momentum. Some products offer exposure to individual risk factors, while others aim to provide a portfolio of risk factor investments via a single investment.

The interest in this way of investing stems partly from academic research, which suggests that over the long term, passive exposure to certain risk factors can outperform passive exposure to traditional market risk.

It is also partly from a growing consensus that investors need to broaden their mindsets beyond narrow asset class definitions and
look for diversification across several risk and return sources.

Conventional portfolios of equities and bonds are dominated by equity risk in times of market stress, when markets tend to become more correlated.

In the past therefore – as was shown in 2008 – when an investor may have assumed they had a well diversified portfolio, with implicit downside protection, in fact they had a portfolio of assets that could quickly become highly correlated and highly volatile.

Even the endowment models that seek diversification through allocation to alternative investments have struggled to achieve true diversification when most needed.

A definition

The risk premia is defined as the premium for holding a risky investment relative to a risk-free investment. The singling out of a single risk premia can be achieved via a long/short strategy that provides the desired single factor exposure on the long side while neutralising other risk factors through the short exposure.

Take the momentum risk factor, for example. Academics who have examined stock price performance over time have found that share prices on an upward trajectory over a period of three to 12 months have a higher than expected probability of continuing on that upward trajectory over the subsequent months.

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