It’s been well-documented that, in equity investing, assets have earned premiums because they are exposed to the risks of a certain factor. Given that the literature provides us with a veritable factor “zoo” (there are more than 300), for investors to consider adding exposure to a factor, it should meet the following criteria:
The advantage of using a parsimonious factor approach is that it provides a framework for assessing risk and, thus, is helpful in designing portfolios. Another benefit of factor models is that they allow us to determine if the returns earned by active managers are the result of alpha, or if they are due to exposure to common factors (exposure that can be obtained more cheaply through low-cost, passively managed vehicles such as index funds and ETFs).
Among the equity factors that meet these criteria are market beta, value, size, momentum and profitability/quality. In fixed-income investing, two of the most well-known factors are term and credit (default).
Factors In Fixed-Income Study
Ramu Thiagarajan, Douglas Peebles, Sonam Leki Dorji, Jiho Han and Chris Wilson have contributed to the literature on factor-based investing with the paper “Factor Approach to Fixed Income Allocation,” which appears in the Spring 2016 issue of The Journal of Investing. Following is a summary of their findings:
Just as in the case with equities, investors have a wide variety of alternative assets from which to choose when allocating the fixed-income portion of their portfolio. Given that there can be dramatic differences in exposure to economic growth, rates and volatility among the various alternatives, it is critical that investors understand the risks to which the alternative exposes them.
Only then can investors evaluate how the addition of an alternative impacts the risk and expected return of the entire portfolio. Remember, it’s not how an asset performs in isolation that matters. Instead, the important element is how its addition impacts the entire portfolio. The factor approach outlined in the authors’ study is an important tool in creating the proper balance.
This commentary originally appeared June 27 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE