Purifying Factor Premiums in Equity Markets

An interesting academic paper related to a lot of seasonality strategies, but mainly to:

#7 – Volatility Effect in Stocks – Long-Only Version
#14 – Momentum Effect in Stocks
#26 – Value (Book-to-Market) Anomaly
#229 – Earnings Quality Factor

Authors: de Carvalho, Xiao, Soupe, Dugnolle

Title: Diversify and Purify Factor Premiums in Equity Markets

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2894171

Abstract:

In this paper we consider the question of how to improve the efficacy of strategies designed to capture factor premiums in equity markets and, in particular, from the value, quality, low risk and momentum factors. We consider a number of portfolio construction approaches designed to capture factor premiums with the appropriate levels of risk controls aiming at increasing information ratios. We show that information ratios can be increased by targeting constant volatility over time, hedging market beta and hedging exposures to the size factor, i.e. neutralizing biases in the market capitalization of stocks used in factor strategies. With regards to the neutralization of sector exposures, we find this to be of importance in particular for the value and low risk factors. Finally, we look at the added value of shorting stocks in factor strategies. We find that with few exceptions the contributions to performance from the short leg are inferior to those from the long leg. Thus, long-only strategies can be efficient alternatives to capture these factor premiums. Finally, we find that factor premiums tend to have fatter tails than what could be expected from a Gaussian distribution of returns, but that skewness is not significantly negative in most cases.

Notable quotations from the academic research paper:

"In this paper we show the importance of portfolio construction when it comes to capturing factor premiums efficiently. We first show that the simplest and most traditional approaches to factor investing tend to generate lower risk-adjusted returns because of uncontrolled risk and unwanted exposure to the market index or market capitalization biases. We show that strategies that target constant volatility and hedge the market beta and exposure to size deliver higher information ratios. This is in particular due to a reduction in volatility.

We also show the importance of removing sector exposure as an additional source of risk without return in factor investing. And we explain why long only factor investing can rather efficiently capture factor premiums, in particular from the low risk and momentum factors. Additionally, we demonstrate the importance of diversifying factors in each style thanks to the decorrelation of factor returns even within the same style.

Finally, we show that factor premiums tend to exhibit fat tails, but also a relatively small skewness.

Overall, we defend the importance of purifying and diversifying factor exposures in factor investing as one way of significantly improving risk-adjusted returns from factor strategies. And although this causes turnover to increase due to the need for additional trades, we highlight the fact that most of the benefits shown in this paper can be captured in practice by using clever approaches to contain turnover."


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