Swedroe: Managing Risk With Factors

November 17, 2017

What If Factor Premiums Decline?

Given that research has shown factor premiums tend, on average, to shrink by about one-third post-publication, Scott and Cavaglia then considered what would happen if the factor premiums shrunk to half the historical levels.

As the following table shows, the portfolio of factor premiums continues to mitigate most of the unfortunate tail (the lower 5%) of the cases in which the investor’s terminal wealth is lower than at the starting point while improving terminal wealth in almost all other cases—the 1/N overlay portfolio has higher terminal wealth in all percentiles, and avoids a loss even at the first percentile. 

 

Swedroe: Managing Risk With Factors

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The authors also performed an interesting test. They compared the performance of a portfolio fully invested in global equities managed by an investor with market-timing skill set at 10% (they could accurately forecast 10% of bear markets, a high hurdle given the lack of evidence supporting the view that bear markets can be forecasted) with the performance of a strategy fully invested in global equities and an overlay of equal-weighted factor premiums.

They found that the distribution of terminal wealth across all percentiles is greater for the factor premiums strategy than for the skill-based strategy. In other words, the factor premiums strategy dominates the skill-based one, creating a very high hurdle for active management in terms of ability to time markets.

Does Factor Diversification Make The Road Less Bumpy?

Scott and Cavaglia next tested to see if the factor portfolio allowed investors to “sleep better,” perhaps improving their ability to stay disciplined and avoid panicked selling. They noted that the median value of the drawdowns for a strategy fully invested in the market was 0.43 (a loss of 43%), suggesting investors will be exposed to at least one sizable, nasty event on their journey to achieving their retirement goals.

The authors found that the overlay portfolio can smooth the ride, providing smaller drawdowns at every percentile, even with the 50% haircut to the premiums applied.

Scott and Cavaglia also considered the utility of the downside protection. The research shows investors are, on average, risk-averse. Therefore, they are willing to “buy insurance” (accept lower expected returns) to protect against downside losses. Using utility functions, with varying degrees of risk aversion, they found that, in all cases, the value of downside protection provided by the factor overlay portfolio (benchmarked against the market P&L) is economically large and significant, emphasizing the factor overlay portfolio’s protection against individuals’ aversion to losses.

Summary

Scott and Cavaglia showed the distribution of terminal wealth of a market portfolio strategy can be significantly enhanced via an overlay that allocates capital equally across the four premiums they studied.

In particular, the factor exposures help to mitigate downside risk. Importantly, their simulations demonstrated that, even if the means of the premiums were halved, their drawdown mitigation properties would be preserved.

Finally, they showed that active asset allocation strategies require significant market-timing skill to outperform a passive factor-premium-based overlay strategy.

Post Script

Kevin Grogan and I are working on an update to “Reducing the Risk of Black Swans.” It will include not only more recent data and evidence from the latest research, but also a discussion of certain alternative investments with unique sources of risk and return, and how they broaden the opportunity set and allow for building even more efficient portfolios. We hope to have it published early next year.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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