Smart factor investing
By Noël Amenc, EDHEC-Risk Institute – Two of the main points of criticism of cap-weighted indices, which only offer limited access to the risk premia of equity markets, are the following:
- Poor exposure to a small number of poorly rewarded risk factors such as growth and large cap.
- Concentration in a small effective number of stocks, which leads to an excessive presence of non-rewarded specific risk and therefore low returns for a given level of risk.
Cap-weighted indices do not give access to the risk premia of factors, apart from the market factor, and even for the market factor, only offer inefficient access to the risk premium due to the presence of non-rewarded stock-specific risks relating to the high level of concentration.
By proposing indices with contrasting factor exposures that correspond notably to factors whose reward is well documented in the academic asset pricing literature (value, momentum, size) or to anomalies that correspond more to an approach that is behavioural or explained by limitations (e.g. a leverage constraint) that prevent rational agents from acting in an optimal manner, ERI Scientific Beta allows investors to distance themselves from the poor factor exposure of cap-weighted indices.
By associating an effective choice of weighting scheme in terms of diversification with this choice of factors through stock selection, ERI Scientific Beta also allows the defect of the strong concentration of cap-weighted indices to be remedied in favour of sound diversification that aims to provide the best return for a given level of risk (Sharpe ratio). The concern for the diversification of smart factor indices proposed by ERI Scientific Beta allows their non-rewarded or specific risks to be reduced.
This category of specific risks corresponds to all the risks that are non-rewarded over the long run, and therefore not ultimately desired by the investor, but that can have a strong influence on the volatility or the maximum drawdown of the index (in absolute terms) or the tracking error or maximum relative drawdown of the index (in relative terms).
Specific risks can correspond to important financial risk factors that do not explain, over the long term, the value of the risk premium associated with the index. There are many of these non-rewarded financial risk factors. The academic literature considers for example that commodity, currency or sector risks do not have a positive long-term premium.
These risks can have a strong influence on the volatility, tracking error, maximum drawdown or maximum relative drawdown over a particular period, which might sometimes be greater than that of systematically rewarded risk factors (e.g. exposure to the financial sector during the 2008 crisis or to sovereign risk in 2011).
In line with portfolio theory, among the non-rewarded financial risks we also find specific financial risks (also called idiosyncratic stock risks) which correspond to the risks that are specific to the company itself (its management, the risk of the poor quality of its products, the failure of its sales team, the relevance of its R&D and innovation, etc.).
Specific or non-rewarded risks can also correspond to operational or non-financial risks that are specific to the implementation of the diversification model. It is better to avoid this risk by investing in a well-diversified portfolio.