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When factors disagree

30-09-2014 | Research | Bart Van der Grient, David Blitz, PhD, Pim van Vliet, PhD Generic strategies designed to harvest a certain factor premium regularly conflict with other factor premiums. We find that the premiums associated with these strategies tend to shrink, sometimes even to zero, in these periods of factor disagreement. But enhanced factor strategies avoid stocks that are unattractive on other established factors and continue to deliver when generic factor strategies struggle.

Speed read:
  • Generic factor indices often conflict with other established factors
  • Robeco’s enhanced strategy avoids stocks that are unattractive on other factors
  • Enhanced strategies offer stronger, more consistent performance

Two approaches: generic and enhanced
A factor investing strategy can be implemented in various ways. The main distinction that can be made is between generic approaches and enhanced approaches. The generic approach is to passively follow an index which is designed to actively benefit from a factor premium using a fully transparent, rules-based approach. A potential pitfall of such indices is that although they may provide exposure to a certain factor, they may, at the same time, be conflicting with other established factors. This is actually not unusual. For instance, value-tilted indices can become quite risky at certain times, thereby betting implicitly against the low-volatility premium, and momentum strategies have the structural tendency to select stocks which have become quite expensive.

Going against the value premium can also be a concern for generic low-volatility strategies, which, for instance, exhibit a higher P/E than the market in recent years. Robeco’s enhanced factor strategies are different, because one of their distinguishing features is that they are explicitly designed to avoid stocks that are unattractive on other established factors.

The performance of generic and enhanced factor strategies
We have comprehensively examined the performance of both types of factor strategies. We found out that the more (less) a factor strategy is aligned with other factors, the stronger (weaker) its subsequent performance. In addition, the Robeco enhanced strategies turn out to offer a more consistent performance than generic approaches, because a key element of our investment philosophy is taking exposures to other factors explicitly into account.

Enhanced strategies deliver when generic strategies struggle
This improvement is particularly welcome when generic factor strategies struggle, because of their relatively unfavorable exposures to other factors. We observe that the enhanced factor strategies are still able to deliver in these scenarios. For instance, the enhanced momentum strategy generates over 3% outperformance when generic momentum is relatively expensive or risky and therefore hardly able to offer any added value. In a similar fashion, the enhanced low-volatility strategy manages to deliver 2-3% return over the cap-weighted index when generic low-volatility has a relatively high valuation or weak momentum and actually lags.

These results imply that it is crucial to properly align factor exposures when implementing a factor investing approach.
David Blitz

David Blitz, PhD

Head Quantitative Equities Research

“Factor investing, aimed at systematically capturing the value, momentum, low-volatility and other premiums, holds the future.”

Pim van Vliet

Pim van Vliet, PhD

Senior Portfolio Manager
"The low-volatility effect is perhaps the largest anomaly in finance, challenging the basic trade-off between risk and return, as higher risk does not lead to higher returns.
Still, it remains one of the least utilized factor premiums in financial markets."
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Author

David Blitz, PhD
Head Quantitative Equities Research


Author

Pim van Vliet, PhD
Senior Portfolio Manager


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