In the ever-evolving world of finance, the quest for stable returns and risk mitigation remains paramount. Traditional asset classes, such as stocks and bonds, have long been the cornerstone of investment portfolios, but their inherent volatilities and susceptibilities to market fluctuations necessitate a more diversified approach. Enter the domain of alternative risk premia (ARP) – strategies designed to capture returns from diverse sources of risk, often orthogonal to traditional market risks. Our exploration in this blog post delves deep into this subject, shedding light on which ARP strategies can truly serve as robust diversifiers in the complex financial tapestry.

In a game of poker, it is usually said that when you do not know who the patsy is, you’re the patsy. The world of finance is not different. It is good to know who your counterparties are and which investors/traders drive the return of anomalies you focus on. We discussed that a few months ago in a short blog article called “Which Investors Drive Factor Returns?“. Different sets of investors and their approaches drive different anomalies, and we have one more paper that helps uncover the motivation of investors and traders for trading and their impact on anomaly returns.

India is a big emerging market, actually the second biggest after China. We primarily look at developed markets, mostly the U.S. and Europe, and from Emerging Markets, China at most, and we are aware that we neglect this prospective country. We would like to correct this notion and give attention to a country that is (along with China) being cited as a new potential rising superpower and already looking to take the lead of Emerging Markets (EM) countries. Today, we would like to review the paper that analyzes the performance of main equity factors (with an emphasis on the Quality factor) and is a good starting point to understand the specifics of factor investing strategies in India.

Low volatility investing is an appealing approach to compound wealth in the stock market for the long term. This particular factor investing style exploits the popular naive notion that lower (higher) risk must always equal lower (higher) overall returns. But in fact, this naive assumption is not true, as low-volatility investments often yield more than their high-volatility counterparts. While low-volatility investing has many advantages, it also results in some disadvantages. How to overcome them? Bernhard Breloer, Martin Kolrep, Thorsten Paarmann, and Viorel Roscovan, in their study Dissecting the Performance of Low Volatility Investing, propose a solution.

The latest paper by Sak, H. and Chang, M. T., and Huang, T. delves into the world of financial anomalies, exploring the rise and fall of characteristics in what researchers refer to as the “factor zoo.” While significant research effort is devoted to discovering new anomalies, the study highlights the lack of attention given to the evolution of these characteristics over time. By leveraging machine learning (ML) techniques, the paper conducts a comprehensive out-of-sample factor zoo analysis, seeking to uncover the underlying factors driving stock returns. The researchers train ML models on a vast database of firm and trading characteristics, generating a diverse range of linear and non-linear factor structures. The ML portfolio formed based on these findings outperforms entrenched factor models, presenting a novel approach to understanding financial anomalies. Notably, the paper identifies two subsets of dominant characteristics – one related to investor-level arbitrage constraint and the other to firm-level financial constraint – which alternately play a significant role in generating the ML portfolio return.

Cremers, Liu, B. Riley (Apr 2023) share their view on and try to answer the question: how well do factor investing funds perform? They conclude that, on average, factor-investing funds do not outperform. But using active characteristic share (ACS)—an adaption of Cremers and Petajisto’s (2009) original active share measure—, the authors demonstrate that the factor investing funds that match indexes the most have significantly better performance. An equal-weighted portfolio of factor investing funds in the lowest tercile of ACS outperforms an equal-weighted portfolio of funds in the highest tercile by 3.82% per year (t-stat = 3.89) using the CAPM and by 1.08% per year (t-stat = 2.01) using the CPZ6 model.