Country Risk Control Schemes for Factor Investing in Emerging 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. As such 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).

Empirical literature suggests that the same factors that drive cross-sectional returns in developed markets are also persistent in emerging markets. While deviating away from the developed universe shows also attractive risk-return factor strategies, an investment based on the emerging markets universe also exposes investors to additional risks. Particularly, over- or under- weighting some emerging countries relative to a corresponding benchmark index may result in temporary underperformance. On the other hand, it has been shown empirically that country risks are not priced in so it might make sense for investors to avoid them. In this project we aim to evaluate alternative country risk control schemes to avoid unrewarded risks for factor investing strategies in emerging markets.

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Ang, A., W. Goetzmann, and S. Schaefer, 2009. “Evaluation of Active Management of the Norwegian Government Pension Fund Global”. Available at

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.