|
Page 1 of 7
Traditionally, beta has been defined as the return from broad asset class exposure, while alpha has represented additional return from active portfolio management. More recently, however, investors have started to recognize that many sources of return that were considered added value (alpha) actually represent systematic risk premia (beta) (Anson, 2008; Berger, Kabiller and Crowell, 2008). As a result, we have seen a proliferation of new indexes aiming to capture various sources of systematic return. In parallel with the development of return-based indexes, we have also witnessed the launch of several risk-based indexes, which use volatility and correlation estimates to determine the index constituent weights (Demey, Maillard and Roncalli, 2010). A schematic representation of the various sources of return and examples of indexes capturing different types of beta are shown in Figure 1.
Systematic risk factors should be explicitly recognized and integrated into the investment process as they account for a significant percentage of long-term portfolio return (Ang, Goetzmann and Schaefer, 2009).
In general, systematic factors can serve two roles in the asset allocation process. First, in strategic asset allocation, adding long-term strategic exposure to selected risk factors or investment strategies could potentially lower the volatility and improve the performance of the overall portfolio. Second, in tactical asset allocation, systematic factors could facilitate the implementation of short-term investment views or the hedging of unwanted risk exposures.
In this paper, we discuss applications of systematic indexes. We use this term to refer to indexes that capture systematic risk factors or replicate systematic investment strategies.
The next section presents the key risk factors driving global equity portfolio returns and examines their historical track record. We then highlight various approaches to capture these systematic risk factors through indexes and describe their interconnections. After that, we discuss applications of systematic indexes in strategic asset allocation, and then how these indexes can serve as the basis for investment tools and hedging instruments in tactical asset allocation. We also describe the mechanics of adding factor exposure to a portfolio and derive the analytical conditions that imply performance improvements. Finally, we conclude by highlighting potential investment implications.
This paper focuses mainly on systematic indexes targeting equity risk factors and discusses their applications in the investment process. Systematic indexes capturing risk factors or trading strategies from other asset classes such as fixed income and currencies can also serve similar roles in the asset allocation process (Bender, Briand, Nielsen, and Stefek, 2010).
Equity Factors And Their Historical Track Record
The main factors driving global equity portfolio returns fall into three categories; namely, countries, industries and styles. These factors play a vital role in explaining portfolio returns and capture key dimensions of many equity investment strategies. Style factors in particular encapsulate important fundamental or market trading characteristics of equity securities; for example, volatility, momentum, size, value, growth, leverage, liquidity, etc.
Figure 2 summarizes the historical track record of the style risk factors from the Barra Global Equity Model GEM2 (Menchero, Morozov and Shepard, 2008). The summary statistics presented in this table provide valuable insights into the characteristics of equity style factors and their potential role in asset allocation.
In this table, the factors are listed approximately in order of explanatory power and statistical significance, highlighted by the first two columns in the table. Volatility is by far the most important and most volatile factor, followed by Momentum, Size and Value during the observed period. On the other hand, Growth, Leverage, Liquidity and Non-Linear Size have relatively lower volatility and lower explanatory power during the observed period. The third column in the table (Factor Kurtosis) shows that all equity style factors exhibited “fat tails,” and serves as a reminder that empirical style factor returns do not follow the normal distribution.
|
Previous Page
