Factor-Based Active Strategies

Similar to the concept of smart beta, factors are specific characteristics or variables that can influence how investments perform in a portfolio. When using a factor-based strategy, the goal is to identify what might cause a stock's price to go up or down. Managers usually take long positions on positive factors and short positions on negative factors. Positive factors are the ones that are expected to lead to higher stock prices, known as rewarded factors. Factors that don't persist over time are called unrewarded factors, and they can pose challenges for factor-based strategies.

Identifying Factor Performance: The Hedged Portfolio

A well-known factor model in finance is the Fama and French model. They are at times known as the Fama and French ‘three-factor models’. In other instances, and contexts, they are known as ‘five-factor models’. More important than the exact number of factors in the model is the identification of factors that can boost portfolio performance. Fama and French identify factors related to size and value, most notably. The hedged portfolio approach should be market-neutral overall. In other words, it should long and short an equal number of shares, such that the portfolio begins its life with a beta of zero (or close to it). Dollar delta could be another way to measure and analyze the degree of market ‘neutrality’ a portfolio has. The following steps describe the hedged portfolio process at a high level:

Steps:

1. Rank the available stocks by factors, possibly starting globally and then within specific equity sectors.
2. Divide the stock universe into quantiles, like deciles (10% portions).
3. Go long on the best quantile and short on the worst.
4. Monitor portfolio performance over time to assess factor effectiveness.

Drawbacks

• The method ignores mid-quantile factors that might have predictive power.
• It assumes a linear relationship between factors and stock performance, which might not hold.
• Portfolios might seem diversified if many correlated factors are used, exaggerating diversification.
• Shorting stocks for the hedge assume shorting is feasible.
• The hedged portfolio isn't purely based on one factor due to exposure to other risk factors.

These theoretical long-short portfolios are dollar-neutral and have unit exposure to a chosen factor, while other factor exposures are zero. Constructing them can be tricky due to liquidity and short-selling constraints.

Investors restricted to long positions can adjust portfolios towards factors that are likely to beat the benchmark. Small tilts result in low tracking error, making it an enhanced indexing approach.

Types of Style Factor

$$ \small{\begin{array}{l|l|l}
\textbf{Factor} & \textbf{Construction} & \textbf{Risk premium} \\ \hline
\textbf{Size} & {\textit{Long: }\text{Small cap} \\ \textit{Short: } \text{Large-cap} } & {\text{Small-cap stocks have} \\ \text{higher volatility than} \\ \text{larger, more established} \\ \text{firms.}} \\ \hline
\textbf{Value} & {\textit{Long: } \text{Inexpensive stock} \\ \textit{Short: }\text{Expensive stock} } &
{\text{Less expensive stocks may} \\ \text{be more likely to be in} \\ \text{financial distress.}} \\ \hline
\textbf{Price momentum} & {\textit{Long: } \text{Recent outperformers} \\ \textit{Short: } \text{Recent underperformers}} & {\text{Belief in trend persistence} \\ \text{(behavioral biases).}} \\ \hline
\textbf{Growth} & { \textit{Long: } \text{High growth prospects} \\ \textit{Short: } \text{Low growth prospects}} &
{\text{High growth is considered} \\ \text{to be an indicator of a good} \\ \text{future.}} \\ \hline
\textbf{Quality} & {\textit{Long: } \text{Stocks with high-quality} \\ \text{earnings} \\
\textit{Short: } \text{Stocks with low-quality} \\ \text{earnings}} & {\text{High-quality earnings} \\ \text{indicate brighter prospects} \\ \text{for firms.}} \\ \hline
\textbf{Unstructured data} & {\textit{Long: } \text{Best trailing stock price} \\ \text{return} \\
\textit{Short: } \text{Worst trailing stock price} \\ \text{return} } & {\text{Based on novel uses of big} \\ \text{data.}}
\end{array}} $$

Factor Timing

One common type of factor investing is equity style rotation. In this approach, managers predict that various factors will perform differently at different times. When a specific style is expected to do well, the strategy allocates funds to portfolios that focus on those factors.

While analysts build factors, managers might investigate what conditions caused factors to underperform or outperform. They could use regressions to study the connection between factor performance and a variable believed to significantly impact it.

Question

In the hedged-portfolio approach, the expected beta of the portfolio is most likely to be?

1. Negative.
2. Positive.
3. Neutral.

Solution

The correct answer is A.

In the hedged-portfolio approach, the aim is to reduce or eliminate market risk (systematic risk) by taking offsetting positions, often through the use of derivatives. By employing techniques like short selling, options, or futures contracts, the portfolio manager attempts to create a portfolio with a negative beta, which means it moves in the opposite direction of the overall market. This negative beta is intended to hedge or offset market movements, providing a form of risk mitigation.

B is incorrect. A positive beta in a portfolio indicates that it is positively correlated with the market. This means that when the market goes up, the portfolio is expected to go up, and when the market goes down, the portfolio is expected to go down. A positive beta implies exposure to market risk rather than hedging against it, which is contrary to the objectives of the hedged-portfolio approach.

C is incorrect. A neutral beta (beta of zero) in a portfolio suggests that it has no significant correlation with the market. Such a portfolio is not actively hedging against market risk but is instead indifferent to market movements. The hedged-portfolio approach typically aims to actively hedge against market risk rather than maintain a neutral stance.

Reading 25: Active Equity Investing: Strategies

Los 25 (d) Analyze factor-based active strategies, including their rationale and associated processes