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Factor investing with the awareness of liquidity and trading costs

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 this stage, there are still a lot of open questions to be answered. Examples of research questions are: what are other important factors in the equity markets? How to evaluate the factor premiums after trading costs? Are the premiums to be found in the emerging markets as well? How to best allocate to the factor premiums under the cost awareness?

References:
Wilma de Groot, Joop Huij, and Weili Zhou, “Another Look at Trading Costs and Short-Term Reversal Profits”, Journal of Banking and Finance, January 2012.

Amihud, Y. “Illiquidity and Stock Returns: Cross-Section and Time Series Effects.” Journal of Financial Markets, 5 (2002), pp. 31-56.

Roger G. Ibbotson et al. “Liquidity as an investment style”, Financial Analysts Journal, vol. 69, no. 3 (May/June 2013), p. 30-44.

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