Foundations In Factors

Northern Trust
Door juli 11, 2019 07:00

Foundations In Factors

Style factors have been shown to historically deliver superior risk-adjusted returns than passive capitalization weighted indexes and more persistent performance than traditional active management, making them a compelling alternative for investors. The benefits of style factors come with the cost of cyclicality, exposing investors to the risk of sustained underperformance. Although the efficacy of style factors conflicts with modern financial theory, they have been successfully employed for more than 40 years to improve upon passive capitalization weighted equity portfolios. Empirical studies have repeatedly shown style factors outperform capitalization weighted benchmarks across most global markets. These results are considered anomalous because they are inconsistent with the concept that expected return is determined solely by an investment’s sensitivity to the broader market, traditionally referred to as market beta. When considering the role style factors can play in a portfolio, it is helpful to understand their origin, theoretical justification, and relationship with traditional active management. The first section of this paper provides an overview of these topics and establishes style factors as a compelling alternative to passive capitalization weighted investing. Like all investment strategies, style factors are not without potential drawbacks. The second section of this paper demonstrates that style factor investing is susceptible to prolonged periods of poor relative performance. This cyclicality is problematic given that investors commonly evaluate strategies on a three-to-five year horizon and style factors are prone to underperform over such short holding periods, ultimately leading to divestment. In light of these obstacles, we conclude with an illustration of using factor diversification to improve the likelihood that investors realize the benefits of style factors. Although diversification is useful, it is only one method of improving the investor experience. Given the magnitude of the challenge style factor cyclicality presents, we recommend investors seek out portfolios designed explicitly to address this risk. 

Northern Trust
Door juli 11, 2019 07:00


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