Saturday School

Is everything we learnt on diversification untrue?

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Globally, factor investing and smart beta are the fastest growing segments within the asset management space - growing 5 times faster than traditional active management. We've discussed Smart Beta in an earlier edition of Saturday School (Click Here). In this edition, we discuss the exciting new world of factor investing - a segment born out of the realization post 2008 that diversification on the traditional basis of asset classes doesn't really buy you the protection you seek when all asset classes nosedive in a serious market downturn.

Let's take a simple example first to understand what the problem is that factor investing is seeking to address and then we can look at how it is actually being addressed. Consider a fund category all of us are very familiar with - dynamic equity funds. The basic premise is upside participation along with downside protection through nimble changes to asset allocation using a well-defined model. Looks good, so far.

Here's where it starts to look less good: lets assume that there is a sudden, unexpected increase in interest rates, caused by currency volatility. We know that the debt portfolio will get impacted negatively, especially if it has been running a high duration. But what can also happen is that the equity component - which is typically managed by another fund manager, could be hit by the same factor negatively, if for example he was significantly overweight on rate sensitives like banks in his equity portfolio.The fund now gets a double whammy negative blow because both the debt and equity components got impacted by the same factor of risk - interest rates.

The traditional thinking of mixing debt and equity in a portfolio for diversification and risk control suddenly goes out of the window since both are correlated on certain factors while may remain uncorrelated on other factors. Risk factors that impact both asset classes derail the entire traditional thinking on asset class based diversification.

This is where factor investing comes in: it encourages diversification by factors rather than asset classes. It encourages recognizing risk at a portfolio level by factors, rather than by asset classes - simply because there are factors that carry risk across asset classes. When you run a portfolio at a factor level and therefore quantify overall risk by factor (cutting across asset classes), you then start thinking of how to mitigate risk for each factor - either through long/short strategies, use of derivatives and other hedging mechanisms, to actually manage risk more effectively.

Factor based investing is not only about diversification - its equally about extracting great returns from markets by betting on factors rather than sectors. Taking our example of rate sensitivity forward, you can construct an index of large cap rate sensitive stocks which can include banks, other lending businesses, automobiles (especially commercial vehicles which are more rate sensitive) etc and then build an ETF around the factor called rate sensitivity. Investors who want to bet on interest rates falling down can simply buy this ETF and ride their gains.

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Text book definition

Traditional methods of portfolio diversification are relatively easy to understand, such as 80% stocks and 20% bonds. Factor investing is an investment strategy in which securities are chosen based on attributes that are associated with higher returns. Factor investing requires investors to take into account an increased level of granularity when choosing securities; specifically, more granular than just choosing an asset class. Common factors reviewed in factor investing include style, size, and risk. (Investopedia)

Conventionally investing has focused on asset classes, like bonds, equities, commodities or real estate. But each of these asset classes is affected by a variety of factors driving returns and risk. Says Eugene Podkaminer, vice president of capital markets research at Callan Associates; "A metaphor I use to explain factors is if asset classes are like complex molecules, factors are the atoms that serve as building blocks. During a crisis, molecules that were supposed to have different characteristics turn out to be composed of atoms that move together; in other words, asset classes that you typically wouldn't think of as being correlated actually are." He continues, "If we combine risk factors together into a portfolio instead of asset classes, potentially, we can get to a more efficient portfolio-returns that are comparable to the traditional model with a much better risk-adjusted trade off. (Yale Insights, Gene Podkaminer April 15, 2014)

In effect factor investing means that instead choosing individual stocks, an index is built according to specific pre-determined characteristics or factors, shared by groups of stocks. These factors include value, market capitalization and momentum. Factor investing aims to combine transparency, simplicity and low cost of indexing to beat the market. Analysts have identified researched and tested a number of 'factors' that look likely to outperform the market. Using this research, factor based exchange-traded funds have been launched in recent years.

Identifying factors

According to Podkaminer, "At least in my lexicon, to call something a risk factor, it shouldn't be divisible into any smaller part. For example, inflation is very hard to decompose further, versus a bond, which is sensitive to numerous risk and return factors that are macroeconomic in nature-what happens with GDP, real interest rates, and inflation along with asset class-specific things like duration, convexity, and spread." (Yale Insights, Gene Podkaminer April 15, 2014)

An important matter of nomenclature which should be highlighted at this point is the difference between risk premia and risk factor. With risk premia, investors are trying to maximize wealth by holding compensated premia; whereas a risk factor need not be compensated. This is one way of building up criteria for isolating factors for investment.

Grouping factors

In practical terms, factors can be identified and differentiated into separate groups. An equity based group will have factors like size, momentum and value. A macroeconomic group would feature factors like GDP growth, inflation, productivity, real interest rates and volatility. Another group can be for factors like emerging markets, developed markets, sovereign exposure and currency. Fixed income group would include factors like the position of a particular bond in the capital structure of an organization, risk of default, credit spreads, convexity and duration. While this can be done at a highly granular level, by including every likely risk factor, in practise this would be very difficult.

According to Podkaminer, "In the traditional model, when I hold a U.S. bond and a U.S. stock, they're viewed as separate. But there's very important overlap and crosstalk. In a risk factor context, I can put factors together in such a way that I explicitly capture that crosstalk and understand where the overlaps are and where the gaps are. I can't go out there and buy GDP growth or size exposure or momentum or credit spread in a single, easily traded asset that's quoted in the back of the Wall Street Journal. So I have to create factor-mimicking portfolios typically using long-short spread exposures. If I want to replicate something like size, I would be long a global small-cap index and short a global large-cap index to get exposure to that particular factor premium."

The practise of factor investing

The first step to building a factor based portfolio is to define the set of factors that would be used. The number of factors to be taken into account must be set down. Gaps in defining the factors if any should be identified and addressed. Similarly factors that overlap must be identified, while isolating factors that are uncorrelated. Then predictions for returns, risk and correlation for those factors are made. Making these predictions can be very complex. Instead of trying to track and predict the future of a few asset classes one would be looking at twenty or thirty factors. Equally, one would have to go down really deep into the nature and characteristic of each of the factors, to be able to predict with any semblance of accuracy, a particular factor's future trajectory.

"Any portfolio, whether it's constructed with asset classes or risk factors or some other system, needs to be based on ex-ante, forward-looking assumptions. Period. Go back to Markowitz, Sharpe, or any of the pioneers in this space, and it's clear that when putting together portfolios, you really should be looking through the windshield versus the rear view mirror. So in a mean variance optimization model, I need to make a judgment on what the expected returns, and the risk, and the correlations of the different pieces of my portfolio are going to be before I put them together," Podkaminer said.

Characteristics of a factor based portfolio

Basically, a factor based portfolio cannot be a buy and hold operation. The long-short component must be ceaselessly rebalanced. This is a very intensive management operation. If there are ten factors one may have to take twenty long and short positions for each of them. Another thing is that the portfolio will have to be managed through factors or premia. Thus comparisons cannot be made with other investment managers or peer groups. "When I put together portfolios of asset managers or asset management products, I look at volatility, liquidity, size, and style, among others. In some sense, we are just letting these factors and premia bubble up from the implementation arena to the principles that guide the portfolios of institutional investors." (Yale Insights, Gene Podkaminer April 15, 2014)

These assumptions regarding factors should be strong and durable. One need not and should not be reactive to every turn of the market. The efficacy and relevance of the factors can be reviewed probably every once a year. "If I'm a strategic, long-term investor, with hopefully a near-perpetual horizon, I want to be looking at equilibrium relationships amongst asset classes or amongst factors. So I'm not necessarily concerned with performance for next year or three years or even five years out. I'm thinking of a 10- or 15-year horizon. So for something to change, it needs to be not just a marginal change. It needs to be something real like a change in market structure or a long-term secular trend that is going to impact a particular factor or asset class," says Podkaminer. "The middle ground is to take a deeper and more inquisitive look at the asset class building blocks of your current portfolio, and to explicitly make those connections between asset classes which may not come through in the standard risk, return, and correlation modelling."

Is factor investing here to stay?

The answer is yes. Says Podkaminer, "Have we gone through an inflection point where disequilibrium jarred correlations? I think the answer to that is yes. If you look back through history, there have been many violent periods where correlations did change because what was happening from a geopolitical perspective, from an inflationary perspective, from a commodities-influenced perspective, resulted in seemingly unrelated asset classes moving together."

Further there is also the concept of DINO, diversification in name only. That means that while more and more asset classes are created for so called diversification, essentially these are not really very different from each other. They are just smaller and finer slices of extant asset classes. For example what is the logic in distinguish between foreign equity and domestic equity? Or, for that matter, between large cap and small cap? Why should investors discriminate between investments on such basis? There are no clear answers. But 'factors' provide a viable alternative framework for profitable investment.

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