Swedroe: A Factor Focused Book To Read

Although not for novice investors, Andrew Ang’s new book, “Asset Management: A Systematic Approach to Factor Investing,” represents a comprehensive, clearly written and accessible review of the latest thinking in modern financial theory.

It provides some important lessons that investors can learn and implement in constructing well-diversified portfolios. I thought it worth sharing some of the most noteworthy points that Ang—a professor at the Columbia School of Business and an advisor to the Norwegian sovereign wealth fund, the largest such fund in the world—covers in depth.

In his chapter on mean-variance investing, Ang observes that it’s all about diversification, which he defines as the process of exploiting the interaction assets have with each other to build more efficient portfolios. Ang examines several diversification strategies—including mean variance, risk parity, equal weighted  and market weight—and provides explanations of the pros and cons of each.

Caveat Emptor

Given the popularity of risk-parity strategies, I thought it was worth sharing this warning. Ang cautions that sample results for risk-parity strategies look especially good because of the heavy weight such strategies put on bonds, and interest rates have been trending downward for more than 30 years now. This accounts for a large amount of the strategy’s outperformance. He warns that risk parity requires estimates of volatility, and that it overweights assets with low past volatility.

Past volatilities tend to be low precisely when today’s prices are high. Presently, bond yields are at record low levels, and current high prices could end up making bonds risky investments. Ang warns that risk-parity strategies are procyclical because they ignore valuations.

Focusing On Risk

In the chapter on factor theory, Ang explains: “Assets have risk premiums not because the assets themselves earn risk premiums; assets are bundles of factor risks, and it is the exposure to underlying factor risks that earn risk premiums.” He added that these factor risks tend to show up in bad times, such as during the financial crisis of 2008.

Thus, Ang suggests investors change the way they think about diversification, moving away from asset-class allocation to factor allocation. He writes: “Investing right requires looking through asset class labels to understand the factor content.” That’s the same approach advocated by Antti Ilmanen in his excellent book, “Expected Returns.”

In other words, assets are just bundles of factors, and different investors have different optimal exposures to different sets of risk factors.

Tbe Bankruptcy Lawyer’s Portfolio

For example, a bankruptcy attorney, whose labor income negatively correlates with economic cycle risk, might want to overweight his equity portfolio with assets that tend to do poorly in times of financial stress (such as value stocks).

The reason is because the bankruptcy attorney could likely bear the risk more than the average investor and thus earn the expected premium. Assets that tend to perform poorly in bad times, when marginal utility of wealth is high, should have high risk premiums. Investors have their own unique risk preferences and different levels of aversion to risk, as well as their ability to bear certain risks.

Lessons From The Crisis

In this chapter, Ang also discussed some lessons from the 2008 financial crisis. He notes:

“The simultaneously dismal performance of many risky assets during the financial crisis is consistent with an underlying multifactor model in which many asset classes were exposed to the same factors… The commonality of returns in the face of the factor risks is strong evidence in favor of multifactor models of risk, rather than rejection of financial theory as some critics claimed. Assets earn risk premiums to compensate for exposure to these underlying factors. During bad times asset returns are low when these factor risks manifest themselves. Over the long run, asset risk premiums are high to compensate for the low returns during bad times.”

What Ang is trying to explain is that the commentators who argued the events of 2008 demonstrated that diversification failed ultimately drew the wrong conclusion. The right conclusion was that asset class labels can be misleading, lulling investors into the belief that they are safely diversified when they might not be.

In addition, Ang reminds investors that correlations are not constant, and so they need to understand that the correlation of some factors tends to rise during bad times. This tendency must be considered in the design of a portfolio, something mean-variance investing fails to account for.

Details On Factors

In his chapter on factors, Ang walks investors through various macro factors (economic growth, inflation, volatility, productivity risk and demographic risk) as well as through the financial factors of beta, size and value.

He provides economic (rational)—and, where appropriate, behavioral—explanations for the existence of the premiums. He also discusses momentum investing.

Wisdom About Bonds

In his chapter on bonds, Ang looks at the factor risks associated with credit and term, as well as illiquidity, the risks related to monetary policy and the term structure of rates. He explains:

“Most of the upward-sloping nominal yield curve is explained by risk premiums rather than by real interest rates. The variance of the long yield is 20% attributable to variations of real rates, 70% due to movements in expected inflation, and 10% due to changes in risk premium. Thus, expected inflation and inflation risk are extremely important determinants of long-term bond prices.”

He then notes that risk premiums on long-term bonds vary over time and are countercyclical, which explains why there is some ability of the term spread to predict recessions. Recessions have upward-sloping yield curves when risk premiums on bonds are highest, and the peaks of expansions occur when risk premiums are lowest.

Importantly, Ang focuses on the fact that high yields on corporate bonds don’t translate into high returns. Said another way, the default premium has not been well rewarded. He also explains that the credit spread has “uncannily mirrored the changes in liquidity—corporate bonds have large exposures to illiquidity risk.”

He goes into a good discussion on the issue, and concludes that “to harvest the corporate bond risk premium, as modest as it is, investors must be able to stomach strong losses during economic slowdowns.”

There is also an excellent chapter on the low-risk anomaly, which is that stocks with low beta/low volatility have outperformed stocks with high beta/high volatility.

The chapter on “real” assets explores the inflation-hedging allure of various assets. Ang makes it clear that investors need to distinguish between inflation hedging (the correlation of returns and inflation) and the long-run return of assets.

He writes: “An asset having a long-run return much higher than inflation can be a very poor inflation hedge; inflation hedging is a statement about co-movement, while the later is a statement about the long-term mean.”

He demonstrates that most “real” assets, like stocks and real estate, are not so “real.” He also notes that inflation hedging isn’t a reason to own gold. While gold perhaps serves as a safe haven, and thus may have some role in a portfolio, inflation hedging isn’t a reason for owning it. It really is a hedge for disaster risk. Ang also concluded that “most risky assets, including ‘real’ assets are not perfect inflation hedges.”

Which Factors To Invest In

Ang provides investors with four criteria they can use to determine which factors they should choose to invest in. The criteria are from “The Professors’ Report to the Norwegian Ministry of Finance.”

• Be justified by the strongest support from academic research, having an intellectual foundation with compelling logic (whether risk or behavioral). He notes that you don’t need unanimity concerning the mechanism that generates the explanation, which frankly is not likely in finance.
• Have exhibited significant premiums that are expected to persist in the future. Not only should we understand why the premium existed in the past, but there should also be a strong basis for believing it will continue to persist.
• Have return history available for bad times. Factor risk premiums exist because they reward the willingness to endure losses in bad times.
• Be implementable in liquid, traded investments. This is especially important for large investors where scale is required.

He also emphasizes the importance of modeling for each investor to identify the bad times and explore how well losses that materialized in those bad times were handled. Each investor has a unique ability, willingness and need to accept risks.

Ang concludes his book with two excellent chapters on hedge funds and private equity, noting that neither is an asset class. He demonstrates the overall poor performance of both these types of investments, and why published returns are often very misleading, if not outright lies, especially after accounting for risks. I plan to cover these chapters in separate posts later this week.

In summary, Ang’s book would make an excellent addition to the libraries of most investors. I would also highly recommend the following, which are some of the best finance books I’ve read in the past few years: Antti Ilmanen’s “Expected Returns,” James Weatherall’s “The Physics of Wall Street,” Jacques Lussier’s “Successful Investing Is a Process” and Michael Mauboussin’s “The Success Equation.”

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.