Risk Allocation - July 15, 2015

Factor Investing: A Welfare-Improving New Investment Paradigm or Yet Another Marketing Fad?

This paper examines the relative efficiency of standard forms of practical implementation of the factor investing paradigm based on commonly-used factors in the equity, fixed-income and commodity universes.

Investment practice has recently witnessed the emergence of a new approach known as factor investing, which recommends that allocation decisions be expressed in terms of risk factors, as opposed to standard asset class decompositions. To answer the question of whether factor investing is truly a welfare-improving new investment paradigm or whether it is merely yet another marketing fad, the paper identifies mathematical conditions under which it is expected to generate welfare gains for asset owners and provides an empirical measure of such gains.

The study suggests that the most meaningful way to group individual securities is not to form arbitrary asset class indices, but rather to form replicating portfolios for asset pricing factors that can collectively explain cross-sectional differences in security returns.

In this paper, the authors found that the out-of-sample benefits of factor investing are potentially extremely large when short-selling is allowed, and remain substantial in the presence of longonly constraints, especially when improved weighting schemes are used in implementation.

This research was produced as part of the "Risk Allocation Solutions" research chair at EDHEC-Risk Institute, in partnership with Lyxor Asset Management. This chair is examining performance portfolios with improved hedging benefits, hedging portfolios with improved performance benefits, and inflation risk and asset allocation solutions.

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(1) http://docs.edhec-risk.com/mrk/000000/Publication/EDHEC_Publication_Factor_Investing_a_Welfare.pdf