Active, Passive and Smart Beta: Part 3 – From Assets to Factors

This is Part 3 of the 5-part series on Active, Passive and Smart Beta strategies.

In Part 2 (Active vs Passive Investing), we did a detailed analysis of Indian Mutual Funds with respect to the benchmark Nifty 50 index. We concluded that roughly 50% (or less) active managers will outperform the benchmark.

Given this, should an investor just stick to passive index investing or is there a better solution?

In this blog, we introduce systematic risk factors that are building blocks of Smart Beta strategies.

To understand the above statement, we need to first understand the concept of Factors and the Factor theory.

Factor theory – From Assets to Factors

What are factors?

Factors can be defined either in terms of the risk or the return. The “return” definition of Factors states that Factors are anything that helps explain (or forecast) the returns of an asset or security. When used in the context of forecasting returns, Factors are more commonly called Alpha Factors.

The “risk” definition of Factors states that Factors are an exposure to some underlying risk. Note that these 2 definitions are not contradictory because risk and returns are intertwined. However, since our aim is to build up to Systematic Risk Factors and Smart Beta Strategies (and for the sake of homogeneity with asset pricing theories), we will use the risk definition of Factors in this series.

When an investor buys an asset, he takes on different flavours of risks. For example, if you buy shares of a small-cap Company that is trading at a very low PE ratio, you are exposed to following risks (not exhaustive):

• Market risk – If stock market goes down, your stock likely goes down as well.
• Size risk – There are many periods where small-cap stocks severely underperform large-cap stocks.
• Value risk – There are periods of crazy bull run where growth stocks outperform value stocks.

Very simply put, these different flavours of risks are nothing but Factors. Factor theory states that assets are nothing but a bundle of risk factors. In other words, assets themselves do not earn any risk premium (expected excess return over the risk free rate). It’s the bundle of risk factors that earn the risk premia.

Total risk premium of an asset is determined by its exposure to the set of risk factors and their respective premia.

Why do factors earn risk premim? Because factors are nothing but risk. Each factor carries a certain flavour of risk. Risk manifests itself as “bad times” (as defined in Asset Management – A systematic approach to Factor investing) and investors who take exposure to these factors must be compensated (in the long run) for bearing these bad times.

Let’s try to formalise this with a bit of mathematics.

CAPM (introduced in Part 1 and Part 2 of this series) was the first model to recognise the fact that risk of an asset is driven by Factors.

Limitation (one of several) of CAPM is that it considers only one factor – the market. CAPM states that exposure to market is your only source of risk premium – market is the ONLY risk factor that is rewarded.

Multi-factor models recognize that market is not the only source of rewarded risk. The first multi-factor model was Arbitrage Pricing Theory (APT) by Stephen Ross in 1976.

APT stated that there are other factors beyond the market that earned positive risk premia and the ONLY source of expected returns of an asset are the exposure (betas) to these factors. Formally,

ERi - Rf = bi1F1 + bi2F2 + bi3F3 + bi4F4 + … + binFn

APT posited the existence of other “systematic” risk factors (that are rewarded) beyond the market. Smart Beta strategies are direct decedents of the Arbitrage Pricing Theory (we introduced Smart Beta in Part 1 and will discuss in more detail in Part 5).

How many systematic risk factors are there? This is a difficult question. To understand the Factor universe, let’s look at the diagram below:

Broadly, factors are of 2 types – Macro Factors and Investment-style factors. It is very important to note that these 2 types are not separate or independent.

Macro factors include Economic growth, inflation, productivity, demographic risk. Note that macro factors impact all assets and hence all investors.

In our example above, our mid-cap value stock is exposed to these macro factors. Bad economic growth can result in market correction which can impact our stock. If the Company primarily caters to young population, an aging demographics will be bad for our stock.

But most of these macro factors are not directly tradable – you cannot invest in them to extract the associated risk premium. And hence we have investment-style factors. Note that these factors are themselves exposed to the macro factors – they reflect the underlying macro risks in an Economy.

The biggest example of investment-style factor is the market. An investor can easily take exposure to this by buying an ETF or an Index Fund.

Investment style factors are further categorised into 2 types:

• Static factors – these are factors where we can simply buy the tradable instrument like the stock or bond market index. In our example, our stock was exposed to the market factor
• Dynamic factors – these are factors where the risk premium can only be extracted by dynamic management – rebalancing and trading. Examples include Value, Momentum factors (we will introduce these in Part 4). In our example, our stock was exposed to the value factor.

Factors are not to be confused with asset classes. Some factors are asset classes themselves like static factors. However, many dynamic factors cut across asset classes. For example Value factor is not limited to stocks. Carry trade is a classic example of Value strategy in forex market. Similarly, momentum premium has been observed in stocks, bonds, commodities.

Up until now, we have been frequently using the word “systematic”. Now let’s formally explain it.

The most important characteristic of a factor is that it must be “systematic”. This means that the factor cannot be diversified or arbitraged away. In other words, the risk premium associated with the factor will not disappear.

What does this mean?

Many investment strategies, that outperform initially, end up underperforming as more market participants get to know about the strategy. This is due to arbitrage forces at play.

A risk factor is systematic if it’s risk premium does not disappear due to arbitrage forces. Something more fundamental or behavioural must explain the risk premium. Market is the best example of a systematic factor.

Dynamic systematic factors are the cornerstone of Smart Beta strategies (as we will see in Part 5). In the next part, we will look into some dynamic factors and see if they are systematic i.e., did these factors earn risk premium historically and if yes, will the premium persist.