By continuing on this site you have agreed to cookies being placed and accessed by this website. More information and adjusting cookie settings.

Robeco uses cookies to analyze your visit to this site, to share information via social media and to personalize the site and advertisements in line with your own preferences. By clicking on agree or by continuing on this site, you agree to the above. More information and adjusting cookie settings.

AGREE

Robeco uses cookies to analyze your visit to this site, to share information via social media and to personalize the site and advertisements in line with your own preferences. By clicking on agree or by continuing on this site, you agree to the above. More information and adjusting cookie settings.

AGREE

By continuing on this site you have agreed to cookies being placed and accessed by this website. More information and adjusting cookie settings.

Factor investing in equity markets

The institutional asset management industry is shifting to a new paradigm. Several large institutions have recently modified their strategic allocations by changing from a traditional asset allocation approach, in which diversification occurs by explicitly allocating to several asset classes and regions, towards a factor allocation approach, in which diversification occurs by explicitly allocating to different factor premiums. While a traditional allocation approach may have worked in the stable and exceptionally good period of the 1990s, the last years have shown its weaknesses. The burst of the tech bubble, the recent financial crisis and the European debt crisis have made clear diversification has failed since virtually all asset classes moved in the same, downward, direction.

Factor investing entails allocating to factors shown to have a premium. Academic research shows that factor premiums have better risk/return profiles than market-capitalization weighted indices. Several well-known factor premiums in the equities are, e.g, the low-volatility premium (Blitz and van Vliet, 2007), the size premium (Banz, 1981), the value premium (Fama and French, 1992) and the momentum premium (Jegadeesh and Titman, 1993). Factor premiums are not only present within equities, but also within other asset classes. For instance, the low volatility effect is also present in credits (see, e.g., Houweling et al., 2012) while value and momentum also exists in bonds and commodities (see, e.g., Asness, Moskowitz and Pedersen, 2009).

Recent studies have shown empirical support for factor investing. For instance, Carhart (1995) in a study on active mutual funds, and more recently Ang, Goetzmann and Schaefer (2009) for the Norges Bank Investment Management (NBIM), show that a substantial part of active returns can be explained by exposures to risk factors. Based on this insight, Ang, Goetzmann and Schaefer recommend NBIM to more explicitly and directly allocate to these factors. Blitz (2011) confirms that factor premiums, like low-volatility, value and momentum, outperform market-capitalization weighted indices and shows that a simple 1/N allocation to these factors has a much better risk/return profile compared to the market index.

As of now, there are still a lot of open questions to be answered. Examples of research questions are: what are important (exotic) factor premiums? How to design an optimal portfolio based on factor premiums?  Or how should different pension funds allocate to factor premiums given their specific needs?

For a short introduction to Factor Investing, please watch our animation.

References:
Ang, A., W. Goetzmann, and S. Schaefer, 2009. “Evaluation of Active Management of the Norwegian Government Pension Fund Global”. Available at http://www.regjeringen.no

Asness C., T. Moskowitz, and L. Pedersen, 2009. “Value and Momentum Everywhere”. NBER Working Paper

Banz, R., 1981. “The Relationship between Return and Market Value of Common Stocks”. Journal of Financial Economics, 9, 3-18.

Blitz, D., 2011. “Strategic Allocations to Premiums in the Equity Market”.

Blitz, D., and P. Van Vliet, 2007. “The Volatility Effect”.  Journal of Portfolio Management

Fama, E., and K. French, 1992. “The Cross-Section of Expected Stock Returns”. Journal of Finance, 47, 427-465.

Jegadeesh, N., and S. Titman, 1993. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”. Journal of Finance, 48, 65-91.
Share this page:

Are you interested?

Let us know your motivation and send it together with your CV and list of grades to SQ@robeco.nl. For more information call us on: +31 - 10 - 224 2499