By Noël Amenc, Associate Dean for Business Development, EDHEC Business School, CEO, ERI Scientific Beta
In the Autumn 2018 Scientific Beta special issue of the Research for Institutional Money Management supplement to Pensions & Investments, we first show that achieving robust exposure to long-term rewarded factors, good diversification of unrewarded risks, and high levels of investability are key requirements for adding value with factor indices. It is clear that this added value is expressed over the long term, but that risk control options can increase the short-term consistency of the outperformance that investors expect.
In this short-term risk control context, we review the sector risk control option offered to investors by Scientific Beta that has been available on its platform since its launch in 2013. We conclude that the choice of using the sector risk control option is a trade-off between investors’ aversion to short-term risks generated by sector risk and their willingness to harvest factor risk premia in the most efficient way, to achieve the highest risk-adjusted performance over the long run.
On the subject of allocation between factors, ERI Scientific Beta has undertaken extensive research to go beyond the usual approaches based on factor deconcentration or factor balance. In particular, we focus their research on the link between economic states and factor risk premia. We review some of the existing studies in this area from practitioners and then discuss conceptual considerations regarding the selection of relevant variables and propose a methodology for classifying macroeconomic regimes. We analyse the conditionality of factor premia to the macro regimes and give illustrative examples for implications for factor investors.
With more than $34bn in assets replicating our indices, we are now in a good position to observe instances of factor strategy implementation in institutional investors’ allocations. As such, we felt that it was useful in this area to hear from one of their clients, OPTrust, with which we engage in intellectual exchanges that go well beyond a simple client/provider relationship. The portfolio construction team at OPTrust explains its approach to factor investing from a total portfolio construction perspective. We believe that their mission is best accomplished by building a portfolio with balanced exposures across different risk factors, including macro and style factors. Constructing the portfolio in this way has reduced their dependence on common risk drivers, such as equity risk, to earn the returns we need to keep their plan sustainable, at the lowest level of risk.
Finally, since allocating to factors implies that one knows how to identify them and how to measure a portfolio’s exposures to them, ERI Scientific Beta examines factor definitions used in analytic tools offered to investors and contrast them with the standard academic factors. They also outline why the methodologies used in popular tools pose a high risk of ending up with irrelevant factors. Most popular factor analysis tools used by investors deviate from the models used in research because we choose to use factor scores instead of betas. Although scores are easy to compute and present a point-in-time snapshot of portfolio characteristics, factor scores have serious shortcomings when it comes to factor exposure measurement. The consequence of this misalignment is that investors may end up with returns that fall short of their expectations.
The latest issue of the EDHEC Research Insights supplement to IPE proposes the following articles: