Factor investing has become a widely discussed part of today’s investment canon. This paper is the second in a three-paper series focusing on factor investing. In the first paper, "Foundations of Factor Investing," we discussed six factors - Value, Low Size, Momentum, Low Volatility, Yield, and Quality - that historically have earned a premium over long periods, represent exposure to systematic sources of risk, and have strong theoretical foundations. We also discussed how...

Factor investing has become a widely discussed part of today’s investment canon. This paper is the first in a three-paper series focusing on factor investing. In this paper we lay out the rationale for factor investing and how indexation can capture factors in cost-effective and transparent ways.[1] [1] The next papers series cover various aspects of implementation including use cases we have seen.

An accumulating body of empirical research has found positive gross excess returns from exposure to risk factors (or risk premia). Our study was commissioned by the Norwegian Ministry of Finance to explore factor strategies, through the lens of risk premia indices, for large funds. The paper examines equity risk premia, such as value, size, low volatility and momentum, focusing on return, risk, and investability. For portfolios of large scale, we construct risk premia indices which have...

Commodities investing has grown significantly over the last decade given their strong performance and potential benefits in a multi-asset class portfolio. While there are several ways to invest in this asset class, accessing commodities through equities - with a focus on direct commodities producers - is an effective alternative for commodities investors, circumventing many of the challenges associated with purchasing and storing the physical commodities themselves or using derivatives.

Equal weighted indices are among the earliest alternative weighting schemes to market cap weighting. We demonstrate their significant outperformance over the last decade relative to their cap weighted counterparts - outperformance achieved with attractive risk-to-return ratios. We discuss various rationales for equal weighting including greater exposure to smaller cap stocks, reduced concentration versus traditional indexing, and a disciplined rebalancing process.

Many investors recognize that their reference universe should encompass large, mid and small caps, and furthermore accept the investment belief that smaller companies should earn a risk premium over larger ones. Nevertheless, in practice, most of these investors underweight the small cap segment. Institutional investors - particularly in Europe and Asia - tend to have limited small cap representation, even within their own markets.We review various aspects of this puzzle and argue that...

Pairwise correlations have increased to historic highs since the beginning of August. This increase coincides with a historic spike in the importance of market volatility (captured by the Country factor in the new Barra US Equity Model (USE4)) relative to the volatility of other factors like styles and industries. Intuitively, this relationship makes sense since all stocks are exposed to the market. What this has meant for portfolio managers is a marked increase in total or absolute risk but...

Portfolio managers have long suspected that the risk forecast of an optimized portfolio tends to be optimistic. Many have identified the culprit as estimation error in the covariance matrix. Forecasts based on historical asset covariance matrices are particularly sensitive to this error. The bias is reduced dramatically by using a factor model. Even so, factor models still tend to under-forecast the risk of optimized portfolios, especially the risk coming from factors. In this paper, we show...

Both inflationary and deflationary concerns have emerged as global economies continue to struggle with recovery.  In this confusing environment, inflation-protected bonds can play an important role in plan sponsors’ asset allocation dilemma especially in light of yesterday’s Fed announcement of Quantitative Easing (II) implementation plan.  We find that IPBs have exhibited some distinct differences from other asset classes during the past decade. 

This paper highlights the fundamental-based origins of the factor models used at Barra. Barr Rosenberg and Vinay Marathe (1976) first discussed the theory that the effects of macroeconomic events on individual securities could be captured through microeconomic characteristics such as industry membership, financial structure, or growth orientation. This linkage between macroeconomic events and microeconomic (or fundamental) characteristics lies at the heart of the factor model. We...

The analysis of a possible positive relationship between economic growth and stock market returns is interesting both theoretically and practically. Investors often wonder if they should assign higher weight to countries with higher economic performance, hoping that economic growth will eventually show up in equity returns. Although this relationship seems quite intuitive, historically long-run stock price growth has fallen short of GDP growth in many countries. In this bulletin, we use...

In this study, our goal is to adapt mean-variance optimization to produce active portfolios with less exposure to extreme losses than normal optimized portfolios. Specifically, we illustrate how extreme risk can be incorporated into portfolio construction in a straightforward way by constraining the shortfall beta of the optimal portfolio. Our simple empirical examples suggest that constraining shortfall beta may offer some downside protection in turbulent periods without sacrificing...

When there is noise in a covariance matrix, portfolio optimization tends to produce portfolios for which the risk forecasts are underestimates of the true risk. In this paper, we take a closer look at the connection between estimation error and the underestimation of the risk of optimized portfolios. We pay special attention to the case in which returns have a known factor structure. There, the bias in optimization can be reduced dramatically by using a covariance matrix based on a factor...

The 2008 crisis has offered another look at how emerging market stocks have behaved relative to developed markets.  In the aftermath of the crisis, we take a fresh look at emerging markets to explore these questions: Have emerging markets matched growth forecasts? Which segments have performed well? How have emerging markets behaved relative to developed markets?  While in the aggregate, emerging market stocks were not immune to the crisis, there were some clear differences between...

This paper analyzes the impact of constraints on portfolio return and risk, extending the insights of previous research in this area. We show that constraints move a manager's portfolio away from the optimal unconstrained portfolio in two ways. First, they may rein in or increase the risk of the portfolio without impairing its information ratio. Second, they may force the portfolio to take unwanted bets that incur risk but yield no return. As a result, a constrained portfolio consists of...

Misalignment between alpha and risk factors may create unintended bets in optimized portfolios, as shown analytically in Lee and Stefek (2008).  In a March research insight, we introduced a way to mitigate this issue by penalizing the portion of the alpha not related to the risk factors, the 'residual alpha.' Here, we further illustrate this method with two signals commonly used by portfolio managers. The potential improvement from this method depends on the strategy in question, in...

A successful investment process requires a risk management structure that addresses multiple aspects of risk. Here we lay out a best practices framework that rests on three pillars: Risk Measurement, Risk Monitoring, and Risk-Adjusted Investment Management. All three are critical. Risk Measurement means using the right tools accurately to quantify risk from various perspectives. Risk Monitoring means tracking the output from the tools and flagging anomalies on a regular and timely basis....

The misalignment of alpha and risk factors may result in inadvertent and unwanted bets that may hamper performance. Lee and Stefek (2008) show that better aligning risk factors with alpha factors may improve the information ratio of optimized portfolios. They propose four ways of modifying a risk model to reduce misalignment. Here, we discuss one way to mitigate these problems by modifying the optimization process, itself. The objective function is modified to include a penalty term on the...

Fundamental betas provide several conceptual advantages to historical betas--they reflect information on a timelier basis and are less likely to confuse noise for information. This paper revisits the advantages of using fundamental beta for hedging systematic risk in the U.S. Fundamental beta appears to be a more consistent measure for hedging market risk, particularly for investors who care about downside risk and tail risk.

Frequently investors have much more information than they can possibly digest. Developing and employing efficient information processing machinery to handle large amounts of data in a consistent way is the key to success in this environment. In this article we argue that it is critical for international equity asset managers to organize information according to its scope. The structure outlined here categorizes information into three types--global, local, and asset-specific. While we...