Use of Investment Factors

Until this point in the curriculum, risk has been looked at through an asset class perspective, answering the question, ‘What risks are inherent in each asset class?’ Switching to a new paradigm, portfolios may be constructed when viewing risk not through asset classes but by investment factors.

Factors vs. Asset Classes

Typically, in factor-based asset allocations, the factors in question are similar to the fundamental (or structural) factors used in widely used multi-factor approaches to investment. Market premiums and anomalies are usually the basis for calculating factors.

Asset allocation includes several factors besides market exposure (equity), such as size, valuation, momentum, liquidity, duration (term), credit, and volatility. The majority of these factors explained returns that CAPM didn’t explain.

There are several ways to construct these factors. Still, except for the market factor, most of them represent what is known as a zero (dollar) investment or a self-financing investment, in which an underperforming attribute is sold short to finance an offset long position in a better-performing one.

The size factor, for instance, is the return from shorting large-cap stocks and going long small-cap stocks (Size factor return = Small-cap stock return – Large-cap stock return). Realized size returns would be negative if large-cap stocks outperformed small-cap stocks. As a result of creating factors in this manner, they have low correlations with the market and each other, as short positions offset long positions; thereby, most market exposure is removed from the factors.

Question

Which of the following best describes how factor exposures can be incorporated into an investment process?

1. Use factor models to measure each security’s exposure compared to risk factors.
2. Reduce flexibility when making de-risking and hedging choices.
3. Only using return-based factor analysis to navigate uncertainties.

Solution

The correct answer is A:

The investment process can incorporate factor exposures in several ways. Each security’s exposure to specific risk factors can be measured using factor models. In the case of a technology stock, you might have a 10% value exposure and a 20% size or market capitalization exposure. The potential for accurately gauging portfolio risk increases once exposures are determined at the portfolio level.

B is incorrect. Investment firms use factor exposures to create more robust portfolios by focusing on risk drivers across their entire portfolio rather than asset class definitions. It increases flexibility regarding de-risking and hedging choices, potentially resulting in more efficient portfolios requiring less risk to achieve competitive returns.

C is incorrect. The two types of factor analysis are returns-based and holdings-based. An analysis of returns covers a portfolio’s history, while an analysis of holdings examines what the portfolio currently owns.

Reading 5: Principles of Asset Allocation

Los 5 (i) Describe the use of investment factors in constructing and analyzing an asset allocation