Investing in Systematic Factor Premiums

AuthorPhilip A. Stork,Kees G. Koedijk,Alfred M.H. Slager
Date01 March 2016
Published date01 March 2016
Investing in Systematic Factor
Kees G. Koedijk
TIAS School for Business and Society, Tilburg University P.O. Box 90153, 5000 LE Tilburg,
The Netherlands; and CEPR
Alfred M.H. Slager
TIAS School for Business and Society, PO Box 90153, 5000 LE Tilburg, The Netherlands
Philip A. Stork
VU University Amsterdam Faculty of Economics and Business Administration, De Boelelaan 1105,
1081 HV Amsterdam, The Netherlands; and Tinbergen Institute Amsterdam
In this paper we investigate and evaluatefactor investing in the US and Europe for
equities and bonds. We show that factor-based portfolios generally produce
comparableor better portfolios than market indices.We expand the analysis to other
asset classes and factors, work with other optimisation methods and add a basic
liability structure.The results do not depend on adding other asset classes or on the
removal of a specic factor. Finally, we study the results for a worldwide investor
who invests beyond the US andEurope. Over the longer term and with consistently
applied factor diversication, factor investing appears to be advantageous.
Keywords: portfolio management, factor investing, diversification, optimisation
JEL classification: G11, G12, G23
1. Introduction
Diversication is one of the key fundamental investment concepts, both in theory and in
practice. It even has the status of being the only truly free lunch in the world of
We thank the Editor (John Doukas) and an anonymous referee for excellent comments and
suggestions. We are also grateful to Robeco and especially David Blitz, Joop Huij, Simon
Lansdorp, Roderick Molenaar and Tom Steenkamp for comments, support and data. We
thank the participants of the Robeco seminars in Amsterdam, The Hague and Frankfurt, and
the seminar participants at Erasmus University Rotterdam for helpful suggestions. Any
errors are the responsibility of the authors. Correspondence: Kees G. Koedijk.
European Financial Management, Vol. 22, No. 2, 2016, 193234
doi: 10.1111/eufm.12081
© 2016 John Wiley & Sons, Ltd.
investment (Ilmanen, 2011). The idea is that by combining investment categories, you
can limit a portfolios price volatility without affecting expected returns. However, since
the 20072009 nancial crisis, when almost all investment categories declined en masse,
this received wisdom is being increasingly criticised. In short, the investments turned out
to be not as diversied as expected. And that begs the question: Is it then possible to
effectively diversify a portfolio? Does this mean a portfolio has to be structured
differently, or even that another type of portfolio altogether needs to be constructed?
Investing using factors is one such approach. Investors and researchers were already
aware of this approach, and have identied many factors over the years. The interest in
factors only got the boost it needed when in 2009 the Norwegian Government Pension
Fund requested researchers Ang, Goetzmann and Schaefer to study the results of the
funds active management. The results of active management turn out to be more closely
related to market developments than had previously been thought. The researchers
analysed this effect, ascribing the results for a large part to factors that demonstrate a
more systematic character, rather than to factors of a more transient nature to which
active managers were more likely to allocate. This result triggered other investors to
question whether they themselves were actually aware of the systematic factors behind
their investments, and how a greater understanding of these factors could improve the
investment process and results.
This article reects that line of research. This paper provides a broad, comprehensive
overview and extension of research into factor investing, touching upon relevant debates
and developments. We also add to the existing empirical results. Considerable focus has
traditionally been on the US data while this paper focuses on the European as well as the
US market data and factors, (re)afrming the relevance of factor investing for the
institutional investors in Europe as well. One of the contributions of this paper is
the continued focus on relevance for institutional investors, which is visible throughout
the paper. Factor investing is extended for bonds and its effects are tested on portfolios
based on both equities and bonds. Additionally, liabilities are added to the analysis,
mimicking the fundamental choices that trustees and investment committees face.
Overall, the picture emerges that factor investing calls for more knowledge and research
into embedding this into the investment process, due to its apparent advantages from a
duciary investment perspective.
The sections are structured as follows. Section 2 places the attention on factor
investing in a wider context. The aim of this section is to examine the relevant literature,
and to answer the question as to why this subject is such a live one. Section 3 then
introduces the factors. What is the theoretical support for them, and what are the pros and
cons? Section 4 practically eshes out the theoretical view of section 3 with historical
data series. We compare in plain terms how a portfolio based on investment categories
performs differently than a portfolio using factors and we assess the robustness of the
results. Various optimisation methods are compared in section 5. Section 6 studies
factor-oriented investing if liabilities are present. Section 7 summarises the key ndings.
2. Factor Investing in Perspective
Factor investing is increasingly in the spotlight. The concept is also known as
risk-premia investing, or investing in risk premiums. Other investors call it smart beta.
What all these terms have in common is that investors try to identify sources of return and
then attempt to dene how they can capitalise on them effectively. One new aspect of this
© 2016 John Wiley & Sons, Ltd.
194 Kees G. Koedijk, Alfred M.H. Slager and Philip A. Stork
development is that it goes further than active, versus passive, adjustment to benchmark
or the development of an effective investment strategy. So what is it then? It revolves
around an advanced understanding of the key choices faced by investors.
To handle this subject properly it is worth taking a step back and assessing how and
why investing using factors has gained so much traction of late. We can identify three
distinct periods in this process: the foundation of the investment profession, the quest for
diversication and the subsequent emerging role of factor investing.
2.1. Period 1: foundation
We can comfortably place the rst period in the founding years of the profession. Over
the course of the 1970s, academic insights gained greater acceptance among investors.
The growing awareness of the increasing complexity and of complicated market
conditions demanded that investing become a serious discipline (for an overview, see
Bernstein, 2007). For example, Markowitz (1952) developed the concept that divides
investing into three elements: return, risk and correlation. There is a connection between
expected returns and risk exposure. Higher returns can only be realised with the
acceptance of greater risk. Total portfolio risk can be reduced by spreading the portfolio
over investments that are not fully correlated. Sharpe further adapted this model for
investment practice, dividing risk into unavoidable risk and avoidable risk. Part of the
risk, the so-called systematic risk, of each individual investment is unavoidable. It is
caused by general economic developments in the market, or the common characteristics
of the investment itself: equity investors run different risks than bond holders. Systematic
risk cannot be limited by diversication, so this part of the portfolios risk prole should
be compensated in its expected return requirements. It is a different matter with the other
part of the risk, so-called specic risk, as that can be reduced using diversication.
In 1976, Stephen Ross further expounded systematic risk in his Arbitrage Pricing
Theory (see Ross, 1976). If the investor bases his expected risk on a systematic risk he is
exposed to, and that systematic risk changes due to various economic inuences, is it
then not more practical to relate returns directly to those various economic inuences? In
short, changes in expectations can be explained by the sensitivity to different economic
factors. But what are these then? Chen et al. (1986) nd that macroeconomic factors
unexpected ination, economic growth, investor condence and changes in the yield
curve have a clear inuence on equity returns. In their view, a good factor is one that is
primarily expressed in unexpected movements, has a distinctly non-diversiable effect,
for which information is rapidly and easily accessible, and for which a solid economic
argument can be put forward. Because this approach offers all sorts of benets (such as
the supposed linear relationship between factors and returns), for many asset managers it
forms the basis for their portfolio and risk-management systems.
2.2. Period 2: renement and diversication
Model development goes hand in hand with the growth of nancial markets, especially
since the end of the 1980s. For various reasons, at that time equities were becoming
increasingly attractive. However, from the end of the 1990s the rise of the second period
occurs, with diversication playing a key role. Investors look back to the 1990s as the
period of equity investment. At the same time, there was a growing awareness that this
was not sustainable as with any investment the risk of a bubble increased over time. The
© 2016 John Wiley & Sons, Ltd.
Investing in Systematic Factor Premiums 195

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