Alternative Investments. Black Keith H.

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      Several important observations can be made from Exhibit 2.10. First, both risk factors have generated significant positive returns over a long period. Second, both risk factors are volatile, which means they may not consistently generate positive returns, and there will be periods during which they could generate negative returns. Third, the two factors are negatively correlated (–0.41) with each other and are not highly correlated with the market risk. The fact that the two factors have been negatively correlated in the past is one of the key benefits of factor investing in the sense that two sources of returns have been discovered that are negatively correlated. This means a portfolio of the two should be far less volatile, which is confirmed by the last column of the exhibit. From Exhibit 2.10 the potential benefits of factor investing can already be seen. By isolating risk factors and investing in them, one might be able to avoid those risks that are not rewarded by the marketplace and, as a result, create portfolios that display more attractive risk-return properties.

      As was mentioned, academic and industry research has uncovered a number of risk premiums. Following is a partial list of the best-known risk factors:

      

VALUE PREMIUM: Based on the return earned by stocks with high book values relative to their market values. The strategy is to take long positions in stocks with a relatively high ratio and short positions in stocks with a relatively low ratio.

      

SIZE PREMIUM: Based on the rate of return earned by small-cap stocks. The strategy is to take long positions in small-cap stocks and short positions in large-cap stocks.

      

MOMENTUM PREMIUM: Based on past performance of stocks. The strategy is to take long positions in past winners and short positions in past losers.

      

LIQUIDITY PREMIUM: Based on the risk premium earned by illiquid assets. The strategy is to take long positions in illiquid assets and short positions in similar but otherwise liquid assets.

      

CREDIT RISK PREMIUM: Based on the credit risk of bonds. The strategy is to take long positions in bonds with low credit quality and short positions in bonds with high credit quality.

      

TERM PREMIUM: Based on the riskiness of long-term bonds. The strategy is to take long positions in long-term bonds and short positions in short-term bonds.

      

IMPLIED VOLATILITY PREMIUM: Based on the risk premium earned by the volatility factor. The strategy is to be short the implied volatility of options (e.g., create a market-neutral position using short positions in out-of-the-money puts and short positions in stocks).

      

LOW VOLATILITY PREMIUM: Based on the return to low volatility stocks. The strategy is to take long positions in low volatility stocks and short positions in high volatility stocks. The same strategy can be implemented using betas.

      

CARRY TRADE: Based on the return to investments in high-interest-rate currencies. The strategy is to take long positions in bonds denominated in currencies with high interest rates and short positions in bonds denominated in currencies with low interest rates.

      

ROLL PREMIUM: Based on the return earned on commodities that are in backwardation. The strategy is to take long positions in commodities that are in backwardation and short positions in commodities that are in contango.

      2.5.3 Risk Premiums Vary across Risk Factors

      Do all risk factors offer the same risk premium? The answer to this question has already been provided by the two factors that were presented in Exhibit 2.10. Those two factors offered different risk-return profiles. Different risk factors offer different risk premiums, and the sizes of the risk premiums are not constant through time. Therefore, while a passive allocation to several risk factors could produce attractive results, a more sophisticated approach would consider the size of the premium attached to each risk factor and create an asset allocation that would take advantage of changes in risk premiums. In other words, it might be beneficial to apply tactical asset allocation to risk factors by assigning higher weights to risk factors that are believed to be offering more attractive risk premiums. In addition, academic research has shown that those risk factors that provide poor returns during bad times are the ones that provide attractive returns during normal times. Risk premiums associated with legitimate risk factors are there because these factors perform poorly during bad times. Investors should be willing to hold them only if they provide attractive returns during normal times. Actually, the first step in determining whether an observed source of return is a legitimate risk factor is to compare its return during good and bad times. If the factor provides an attractive return during good and bad times, then it is not a risk factor – it is an arbitrage opportunity.

      2.5.4 Risk Factor Returns Vary across Market Conditions

How do these risk premiums behave through various stages of a business cycle? Exhibit 2.11 displays the rolling 24-month average returns on the two factors discussed in Exhibit 2.10.

      Clearly, these two factors display significant time variations. As previously mentioned, we must expect factor premiums to display some volatility and to perform differently during various stages of the business cycle. If there were no risks, then there would be no premiums. For instance, the book-to-market factor (i.e., value factor) tends to produce attractive risk-adjusted returns during normal market conditions but have poor risk-adjusted returns during economic downturns.19 The momentum factor tends to produce positive returns most of the time but has a tendency to display large negative returns over a short period of time when a market correction takes place. Momentum is notorious for performing poorly during momentum crashes. A momentum crash occurs when those assets with recent overperformance (i.e., those assets with momentum) experience extremely poor performance relative to other assets (Asness et al. 2010). In the same way that investors have learned to hold diversified portfolios in terms of asset classes, they should hold diversified portfolios in terms of risk factors.

EXHIBIT 2.11 Rolling 24-Month Average Returns to Factors

      Source: K. French Data Library.

      2.5.5 Risk Factors and Investability

      Are all risk factors investable? While 20 years ago it might have been difficult and costly to create investment strategies that represented various risk factors, financial innovations of the past two decades have substantially reduced the cost of such strategies. For example, in recent years, exchange-traded funds (ETFs) have become available that track value, volatility, momentum, size, and roll factors. These strategies are often described СКАЧАТЬ