After attending a conference that highlighted some of the latest research on smart-beta and factor-based investing, I can say that this new focus is taking the industry by storm. There was no discussion about allocation to asset classes except in the context of benchmarks and the "old" approach. There is no questions that factor-based approach is a more nuanced view on risk allocation, but there is going to have to be more education on how this research can be implemented and what are the right factors.
One of the clear advantages of factor-based investing is that it can better target the unique (orthogonal) risks in the portfolio. Unfortunately, there is growing number of factors that are being discussed as potential risks. The market has moved well beyond a Fama-French three factor model approach, but how many risk factors are out there and how many are truly needed is very much up for debate. there is no set standard don what is a good factor and I believe the factor used will differ based on the type of manager you are. A global macro manager will be looking at macro risk factors cross equities while a long/short equity manager will have a focus on cross-sectional differences within a set of country-specific stocks.
Regardless of the discussion on what factors, the focus on diversification across risk factors is better than just asset class diversification. Too often when there is a common shock to the markets correlations across asset classes move to one. This movement to a correlation of one is the disappointment with traditional diversification and a key driver for factor-based work especially with respect to macro factors.
Factor-based work also better identifies and isolates the inherent risks in a portfolio whether size, profitability, value, momentum, growth or inflation. Not until risks are identified can they actually be managed.
However, it is the dynamic use of factors where there is the potential for true excess returns. Factors may be time varying, so the management of factors is the next level of advancement. The management of factors could be called strategy. Hence, we believe that strategy is the bets form of diversification and allows for the greatest amount of diversification.
Andrew Ang of Columbia U. has used the analogy that asset classes are meals or food while factors are the nutrients in the meal. If that is the case, then strategy is the cooking of the food and nutrients. A great chef can make your meal better.
Regardless of the discussion on what factors, the focus on diversification across risk factors is better than just asset class diversification. Too often when there is a common shock to the markets correlations across asset classes move to one. This movement to a correlation of one is the disappointment with traditional diversification and a key driver for factor-based work especially with respect to macro factors.
Factor-based work also better identifies and isolates the inherent risks in a portfolio whether size, profitability, value, momentum, growth or inflation. Not until risks are identified can they actually be managed.
However, it is the dynamic use of factors where there is the potential for true excess returns. Factors may be time varying, so the management of factors is the next level of advancement. The management of factors could be called strategy. Hence, we believe that strategy is the bets form of diversification and allows for the greatest amount of diversification.
Andrew Ang of Columbia U. has used the analogy that asset classes are meals or food while factors are the nutrients in the meal. If that is the case, then strategy is the cooking of the food and nutrients. A great chef can make your meal better.
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