Sunday, January 12, 2020

Fundamental versus technical risk premia - Are there distinctions?

Risk premia can be classified through two types, fundamental and technical. Fundamental risk premia are associated with scaling on some fundamental factor like value or quality (price/book or earnings per share for value, or debt to equity return on equity for quality). Any risk premia that sorts on non-price factors is fundamentally-based. Technical-based premia are based on solely on price information like momentum, trend, implied versus actual volatility, or carry. This difference may not mean much to most investors, but it will have an impact on the variation or noise and adjustment of the risk premia. 

Technical or price-based risk premia based on the ranking or dispersion for some price criteria are easy to implement since there is only one key input employed and that information can be obtained daily. 

Fundamental risk premia will use information beyond and therefore will be periodic and subject to measure adjustment and lags. Hence, they will be subject to definitional differences. Price to book, price to earnings, debt to equity, and return on equity rankings will be based on selection criteria and accounting measurement. Two modelers can across on the factor yet obtain different portfolios based on accounting assumptions. For the same set of risk premium assumption, a price-based system will give the same answers.

The return dispersion in a price-based risk premia style category will be tighter than the dispersion for a fundamentally-based style risk factor. Consequently, there will be more portfolio return dispersion for fundamentally-based alternative risk premia. More care is necessary for making any portfolio choice. 

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