Indices and Benchmarking - July 05, 2011

Capturing the Market, Value, or Momentum Premium with Downside Risk Control: Dynamic Allocation Strategies with Exchange-Traded Funds

Investors are usually willing to take on risk only if they are compensated for it with greater expected reward. Although such theories as Ross’s (1976) arbitrage pricing theory (APT) suggest that there may be multiple sources of risk, including both systematic risk factor exposures and idiosyncratic risk (Merton 1987; Malkiel and Xu 2006), that are rewarded in equity markets, both empirical financial research and practical investment strategies rely mainly on a market-wide risk factor represented by a broad portfolio of stocks. This reliance is reflected in the dominance of country and regional indices and ETFs that provide exposure to marketwide equity risk for different regions.

There are also, however, many other types of equity exposure that can lead to risk premia. These exposures exploit differences in expected returns across stocks and tilt the portfolio towards stocks with higher expected returns.

Value and momentum are among the most robust return drivers in the cross section of expected equity returns. Starting with Jegadeesh and Titman (1993), the academic literature has provided ample evidence that stocks with high returns in the past yield high returns in the future. The momentum effect is a short-term phenomenon that holds over time periods of one to four quarters of past and future returns.

Another driver of cross-sectional return differences is the value effect. Stocks with low price-earnings ratios or high dividend yields tend to outperform stocks with high price-earnings ratios or low dividend yields. This effect is well known to investment professionals, who have long advocated buying cheap or distressed stocks (Graham 1934), a recommendation whose soundness been confirmed by many empirical studies (Fama and French 1992). Using such strategies on individual stocks, however, may result in large trading costs, thus greatly reducing the return benefits to momentum or value strategy (Korajczyk and Sadka 2004; Lesmond, Schill, and Zhou 2003). An alternative is to use these strategies by sector (Grinblatt and Moskowitz 1999; O’Neal 2000; Scowcroft 2004). Exchange-traded funds (ETFs) are a natural for putting into effect strategies that profit from value and momentum across sector indices, as they are a liquid investment medium.

Although exposure to broad market risk or to value and momentum effects is expected to yield attractive performance over the long run, particular market conditions can hurt investors who are exposed to these factors. When moving away from the market factor and trying to exploit value or momentum effects, investors’ portfolios tend to become more concentrated, increasing drawdown risk.

In this paper, which was produced as part of the "Core-Satellite and ETF Investment" research chair at EDHEC-Risk Institute in partnership with Amundi ETF, we evaluate the access to value and momentum premia gained by using risk-controlled strategies. In particular, we use both the broad market index and value or momentum trading strategies across sectors in a dynamic core-satellite (DCS) portfolio. We assess the risk-control benefits of the DCS portfolios. In addition to the benefits of dynamic risk budgeting, the paper highlights the role of ETFs in value and momentum trading strategies that are often perceived to be strategies for individual stocks. A contribution of this paper is to apply value and momentum investing to exchange-traded funds, thus focusing on sector-level effects.

This study was produced as part of the research chair on “Core-Satellite and ETF Investment” in partnership with Amundi ETF.

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