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.
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.
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.
As the graph demonstrates, each Risk Premia Index registers positive absolute return over the last 10 years with limited volatility, while also comfortably outperforming a global equity benchmark, such as the MSCI World equity index, for example.
It is also worth noting there is an additional significant diversification benefit in combining the three strategies together.
The challenge for investment professionals now is not only to provide access to these factors, but to work out which factor to recommend to investors at different points in the business cycle, and how to optimally combine risk factor exposures in a single investment designed to perform well over the long term.
• Vincent Denoiseux is a director in Deutsche Asset & Wealth Management’s systematic funds business. The views expressed are his and do not reflect the views of Deutsche Asset & Wealth Management, or Deutsche Bank AG