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Assessing smart beta risk factor performance

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

Similarly, share prices on a downward trajectory over a period of three to 12 months have a higher than expected probability of continuing on that downward trajectory over the subsequent months. This is explained as a momentum effect in stock prices.

To capture this performance in a pure sense, a long/short strategy has to be put in place. This could involve, say, taking a basket of stocks that comprise an established equity index, such as the S&P 500, and analysing each individual stock’s price one month ago compared with the price 12 months ago.

The strategy then combines a long position in those stocks displaying the most positive momentum (which could be the top 10% or
20% of stocks within the index, for example, as measured by the momentum function) with a short position in the index itself.

Other risk factors

Value and quality are another two popular risk factors. The value risk factor comes from academic research, which suggests that stocks assessed as being ‘cheap’ tend to outperform stocks assessed as being ‘expensive’ over the long term, with cheap or expensive worked out on the basis of metrics such as price-to-earnings ratios (P/E).

The quality risk factor stems from the concept that quality rather than quantity of reported earnings is often a better gauge of future performance.

Accruals – the difference between cash and accounting earnings – are a good measure of earnings quality. If good earnings quality is also combined with satisfactory balance sheet quality, profitability, and low leverage levels, then this may lead to future stock price outperformance.

To harness the quality risk factor, a mechanical filtering process could be applied to the stocks that make up an index to single out those companies with quality earnings. A combination of going long the top quality stocks within the index while going short the index would then provide the factor exposure.

Investors like risk factor-based investing because factor exposures can be combined in such a way as to give true diversification, providing for balanced performance over time. But with risk factors now readily available via exchange traded funds and other products, some may want to assess how individual risk factors perform over time relative to each other.

It will be interesting to see how the current batches of new products perform as they mature, but in the meantime we can analyse three Deutsche Bank Risk Premia Indices, on value, quality and momentum, and compare their performance over a 10-year period.

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