Practical Considerations For Factor Based Allocation

February 10, 2015

Exhibit 6 indicates that, on average, these risk premia yielded strong returns historically. However, despite removing significant market exposure their volatilities and maximum drawdowns were relatively high. Moreover, they were susceptible to long periods of underperformance. As an example, the maximum drawdowns of the small-cap and low volatility factors were as high as 42.4 percent and 44.8 percent, respectively, during the examined period.
Figure 2
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On a more positive note, the correlation between risk premia tended to be low historically (Exhibit 7) and the average pairwise correlation between risk premia was almost zero. These results support the findings of Bender et al (2010). Of particular interest, is the fact that they stayed low during the last financial crisis. This is in stark contrast with the average pairwise correlation between asset classes, which was about 0.25 for the whole period, but increased to 0.35 during the financial crisis.
Central to the risk premia portfolio construction process is the exploitation of low correlated risk factors to reduce overall portfolio risk. To illustrate this, we put together a hypothetical portfolio consisting of these 10 liquid risk premia based on a risk parity methodology and compared it with a traditional balanced portfolio comprising 50 percent equities, 40 percent fixed income and 10 percent commodities.
Figure 2
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PracticalConsiderations__Fig_8b
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