It’s been well-documented that, in equity investing, assets have earned premiums because they are exposed to the risks of a certain factor. Given that the literature provides us with a veritable factor “zoo” (there are more than 300), for investors to consider adding exposure to a factor, it should meet the following criteria:
- Persistent: It holds across long periods of time and various economic regimes.
- Pervasive: It holds across countries, regions, sectors and even asset classes.
- Robust: It holds for various definitions (for example, there’s a value premium whether we measure value by price-to-book, earnings, cash flow or sales).
- Investable: It holds up not just on paper, but after considering trading costs.
- Intuitive: There are logical risk-based (economic) or behavioral-based explanations for the premium and why it should continue to exist.
- It isn’t subsumed by other well-known factors.
The advantage of using a parsimonious factor approach is that it provides a framework for assessing risk and, thus, is helpful in designing portfolios. Another benefit of factor models is that they allow us to determine if the returns earned by active managers are the result of alpha, or if they are due to exposure to common factors (exposure that can be obtained more cheaply through low-cost, passively managed vehicles such as index funds and ETFs).
Among the equity factors that meet these criteria are market beta, value, size, momentum and profitability/quality. In fixed-income investing, two of the most well-known factors are term and credit (default).
Factors In Fixed-Income Study
Ramu Thiagarajan, Douglas Peebles, Sonam Leki Dorji, Jiho Han and Chris Wilson have contributed to the literature on factor-based investing with the paper “Factor Approach to Fixed Income Allocation,” which appears in the Spring 2016 issue of The Journal of Investing. Following is a summary of their findings:
- Three factors (the level factor in rates, expectations of future economic growth, and volatility) explain about 80% of the variation of returns in most fixed-income indexes.
- The economic growth (risk) premium for corporate bonds primarily reflects compensation for default risk. Economic growth co-varies with credit risk premiums.
- When it comes to investment-grade credit, the rate factor accounts for a large majority of variation in credit index returns, showing limited exposure to the economic growth factor.
- High-yield and emerging market bonds behave relatively more like equity, as the U.S. rate factor explains only a small portion of the variation in returns. These bonds behave like risky (equitylike) assets, with the vast majority of the variation in their returns explained by the economic growth factor.
- Heightened uncertainty and risk aversion (leading to higher volatility in risky assets) can lead to a flight to safety. Investors seek the safety of high-quality sovereign bonds while they flee from riskier assets, such as high-yield bonds and emerging market bonds (which experience negative returns at the same time equities experience negative returns). Thus, volatility in risky assets can drive returns to fixed-income instruments.
- Treasury inflation-protected security (TIPS) returns are dominated by the level of rate factor, with economic growth explaining about one-third of the variation in returns, and volatility only a very small percentage.
Just as in the case with equities, investors have a wide variety of alternative assets from which to choose when allocating the fixed-income portion of their portfolio. Given that there can be dramatic differences in exposure to economic growth, rates and volatility among the various alternatives, it is critical that investors understand the risks to which the alternative exposes them.
Only then can investors evaluate how the addition of an alternative impacts the risk and expected return of the entire portfolio. Remember, it’s not how an asset performs in isolation that matters. Instead, the important element is how its addition impacts the entire portfolio. The factor approach outlined in the authors’ study is an important tool in creating the proper balance.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.