In this, the fourth of six extracts from ‘Beyond the shadow of quantitative easing’, BNP Paribas Investment Partners’ informative overview of the investment outlook for 2017, Raul Leote de Carvalho, Deputy Head Financial Engineering, explains how factor investing provides diversification into uncorrelated sources of return, which can help investors when traditional asset classes can only deliver low returns.
A factor can be simply thought of as any characteristic that is important in explaining the return and risk of a group of securities. To create exposure to such factors, we tilt equity portfolios and credit portfolios in favour of stocks and corporate bonds, respectively, whose risk and return characteristics are influenced by factors such as value, low risk, momentum and quality. Stocks and corporate bonds that we would seek to overweight are the cheapest, the least risky, the most profitable and those with the strongest past returns.
Value, momentum, quality and low risk factors in fixed income credit
Our most innovative research concerns fixed-income investments and the low-risk premium that can be found across the asset class. Indeed, whether it is government bonds, investment-grade credit or high-yield credit, we have found strong evidence that low-risk bonds can generate a positive premium not explained by their level of risk. More recently, we have shown that there are factor premiums to be harvested through multi-factor investing in investment-grade and high-yield credit from the value, low risk, quality and momentum factors using low-turnover strategies.
Market neutral factor investing
Given that interest rates still remain low, investors seeking higher returns may also want to switch their cash allocation into long-short multi-factor strategies with moderate level volatility. Investors doing so should pay attention to the risk management process in such strategies, making sure that they are indeed market-neutral, i.e. that their beta is indeed zero (see exhibit 3 for an example).
The potential of multi-factor investing
Replacing allocations to individual asset classes with multi-factor exposures has been shown to yield additional returns. Take, for example, a portfolio with an allocation of 50% to world developed equities, 15% to EUR investment-grade bonds, 5% to USD investment-grade bonds, 20% to EUR Treasuries and 10% to one-month Euribor cash. If we had replaced the allocations to equity, credit and cash with allocations to the four multi-factor strategies mentioned, the new multi-asset portfolio would have generated an additional annual excess return of 3.6% from the exposures to the value, quality, momentum and low-risk factors (period covered: 2002 to 2014; source: BNP Paribas Investment Partners). This clearly illustrates the potential of multi-factor investing.
For more information on factor investing, click here.