Luc Dumontier, Head of Factor Investing at LFIS (La Francaise Investment Solutions) and Dr Markus Ebner, Head of Multi Asset at Quoniam Asset Management report on the key findings from the CFA UK Manager Research SIG event held in London on 4 June
Well documented and long-standing risk premia strategies have been exploited in the fund management industry for decades. But are they still practical in today’s world where changes in technology, regulation and new approaches by fund managers are transforming the industry?
Many investors are familiar with factors such as value, quality, momentum when it comes to risk premia. However, the opportunity set expands beyond these traditional long-only factors to include alternative types of strategies like FX momentum, carry and equity market neutral factors.
Given the vast amount of research that has become available on factor investing and the lack of a standardised definition of risk and style premia strategies, understanding the rational that underpins their historical existence is essential for investors considering an allocation to these strategies.
The Holy Grail of combining risk premia through a variety of portfolio construction approaches is to harness premia that exhibit low correlation with others in the portfolio and versus traditional asset classes, with the aim to diversify during periods of stress where drawdown management becomes increasingly important.
But factor timing is very difficult to achieve. Recent history has shown risk premia strategies can correlate, especially during market downturns. LFIS analysis found that during 2018, a significant part of the variance of the negative returns across 30 risk premia funds was explained by losses in just four areas, short volatility, trend following, foreign exchange carry and equity multifactor strategies.
What is noteworthy though is the degree of heterogeneous performance amongst those funds which points towards the importance of portfolio construction and implementation of these strategies. Portfolio construction approaches that consider correlation risk from the outset should provide better diversification during periods of stress.
Source: Bloomberg, LFIS – Panel of 30 Multi asset / Multi Style / Long-Short Mutual Funds selected discretionary by LFIS as being the most representative.
Past performance is neither a guide nor a guarantee of future returns. Return measures in USD
Investment frameworks that have the ability to assess factor exposure to ‘crowdedness’ through systematically analysing investor positioning can be used in portfolio construction as a means to diversify the portfolio’s allocations away from such factors. This is important especially during periods when portfolios that become forced sellers are heavily exposed to the same factors and as such can significantly impact their short-term performance.
Factor Exposure to Crowdedness
Source: Quoniam Asset Management GmbH, Date 1991/12-2019/04. Momentum: 12x1 momentum; Quality: RoE; Value: Book to Price Ratio.
Z-score calculated as standardized exposure to a composite factor indicating the crowdedness of assets.
If diversification is the only free lunch in investing, it is important that investors are able to assess whether risk premia strategies have the potential to deliver. They should try to look beyond the spectrum of over-promising back tested solutions, which are heavily prone to the pitfalls of datamining, overfitting and over-diversification.
As risk premia investing is becoming increasingly popular, managers will look to implement niche developments in the way they extract value either via researching new factors through combining unstructured data with IT skills or by looking to expand the range of premia strategies and enhance implementation.
The market of risk premia investing is growing due to their usage as an uncorrelated and, sometimes, lower cost solution, capacity and cost management. In regards, to their trade implementation they have become very important parameters of the success of these strategies and key elements investors should consider when selecting them.
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