Dimitris Melas

Foundations of Factor Investing

Factor investing is based on the existence of factors that have earned a premium over long periods, reflect exposure to systematic risk, and are grounded in the academic literature. Early financial theory established that for stocks, exposure to the market was a significant driver of returns (e.g., the CAPM). Later, researchers like Barr Rosenberg, Eugene Fama and Kenneth French extended the CAPM to include certain systematic factors that also were important in explaining returns. Tilts towards these factors such as Value, Low Size, and Momentum historically produced excess long-term returns and there were strong theoretical foundations behind these factors. Until now, passive investing has focused on capturing market beta through market capitalization weighted indexes. The only way institutional investors could get access to factors was through active management. Indexation is opening a new way for factor investing today by allowing investors to access factors through passive vehicles that replicate factor indexes. MSCI Factor Indexes provide access to six solidly grounded factors — Value, Low Size, Low Volatility, High Yield, Quality and Momentum. These indexes have historically earned excess returns over market capitalization weighted indexes and experienced higher Sharpe Ratios. This paper is the first in a three-paper series focusing on factor investing.

Constructing Risk Parity Portfolios: Rebalance, Leverage, or Both?

Typical multi-asset-class portfolios can be dominated by equity risk, even when the allocation to equities is relatively modest. Achieving risk parity between equities and fixed income in an unlevered portfolio would require significant rebalancing towards fixed income. While such rebalancing can lead to a reduction in risk, portfolios with high fixed-income allocations have historically underperformed equity-dominated portfolios. However, achieving risk parity through leverage, while keeping the initial asset allocation constant, would typically require substantial levels of leverage and could lead to a significant increase in portfolio volatility. The authors combine rebalancing and leverage to construct risk parity portfolios that target the same expected return and the same portfolio risk as the initial asset allocation and examine the performance of these portfolios in different market conditions.

Efficient Replication of Factor Returns: Theory and Applications

This article presents alternative methods for constructing factor-replicating portfolios, which include portfolios that have unit exposure to a target factor, zero exposure to other factors, and minimum portfolio risk. The authors provide empirical evidence that constrained factor portfolios, with a limited number of assets and relatively low turnover, tracked several Barra equity risk model pure factor returns reasonably well. They also illustrate how factor-mimicking portfolios could have been utilized in the past to enhance both passive and active investment strategies. Factor-mimicking portfolios can be used to hedge out the unintended factor exposures of conventional benchmarks, which are aimed at targeting a particular beta factor, and thus enable plan sponsors to better manage their optimal allocations to beta factor risks. Additionally, factor-mimicking portfolios can be utilized to hedge out the style exposures of active stock-picking strategies enabling active managers to capture pure alpha.

The Perils of Parity

This paper examines the recent trend of adding leverage to fixed income allocations of multi-asset class portfolios of large asset owners. We show that the optimality of adding leverage from a volatility-reduction perspective depends on the correlations between bonds and equities, the relative volatility of bonds versus equities, and the weights of the two asset classes in the portfolio. If correlations between bonds and equities are negative, adding leverage could reduce the volatility of a portfolio, especially if the weight in fixed income assets is low, leverage is moderate, and bonds have a low risk relative to equities. Negative correlations also increase the likelihood that adding leverage will improve the risk-return profile of the portfolio. Asset owners considering adding leverage to their fixed income allocation can examine these influences to decide whether negative correlations between bonds and equities, a low ratio of bond to equity volatility, and higher risk-adjusted returns of bonds relative to equities are likely to persist.

INVITED EDITORIAL: Power to the People: The Profound Impact of Factor Investing on Long-Term Portfolio Management

1. Dimitris Melas 1. is a managing director and global head of Equity Research at MSCI in London, U.K . (dimitris.melas{at}msci.com) In this editorial, I argue that factor investing, also known as smart beta, is having a profound and lasting impact on the way long-term investors construct

Capturing the Value Premium

MSCI Value Weighted Indices are systematic indices that aim to reflect the value premium by employing an alternative weighting scheme that tilts the index towards stocks with lower valuation ratios. In this paper, we review the theoretical aspects of value weighted indices and through empirical studies we discuss the important facets of index construction that underpin the design of MSCI Value Weighted Indices. The MSCI Value Weighted Indices are based on an objective and transparent methodology by which all the constituents of a standard MSCI parent index are re-weighted using four common accounting measures: book value, sales, earnings and cash earnings -- thereby adding a value tilt to the parent MSCI index towards stocks with relatively lower valuation ratios. Based on the empirical results, the MSCI Value Weighted Indices have historically outperformed their respective parent MSCI indices across different regions, reflecting the value premium, with slightly higher risk, low tracking error and modest turnover. The empirical finding on the long term outperformance of MSCI Value Weighted indices is consistent with the long history of published research on the value premium. MSCI Value Weighted Indices are complementary to capitalization weighted indices and could serve as tools in strategic asset allocation to enable investors to gain exposure to market beta with a value tilt.

Managing Risks Beyond Volatility

Minimum volatility strategies enjoy broad support in the academic literature and have been applied extensively by institutional investors to reduce portfolio volatility. In this article, the authors discuss how such strategies can adapt to address risks beyond price volatility. Specifically, concentration, sustainability, and crowding risks could be mitigated using appropriate but simple optimization constraints. However, adding a diversification constraint increased exposure to residual volatility and had a negative impact on risk reduction and risk-adjusted performance. In contrast, to help manage environmental, social, and governance (ESG) risks, adding a significant sustainability constraint had only a small effect on the risk reduction properties. Finally, introducing constraints on the value exposure ensured the market-relative valuations of the strategy remained attractive for only a small increase in realized volatility. The authors show that simple constraints could be used effectively in minimum volatility strategies to manage risks beyond volatility.

Bridging the Gap: Adding Factors to Passive and Active Allocations

The authors examine how a factor allocation can be integrated into an asset owner’s existing roster of active managers. Using a risk-budgeting framework, they have several findings. (1) Asset owners who wish to maintain their existing roster of active managers and incorporate factor views may consider a top-down factor implementation, funded entirely from the core passive allocation. This approach distributed most of the active risk to active managers. (2) Asset owners who wish to preserve their existing roster of active managers and incorporate high-conviction factor views may consider an allocation between active management and a bottom-up factor implementation. This approach more evenly distributed the risk budget to active management and factors and partially funded the factor allocation from active management. (3) Asset owners who pursue a barbell strategy between core passive allocations and concentrated active managers could implement a low-volatility factor allocation, which may lower the total risk of the equity program, releasing active risk budget that can be deployed to active managers.

On the Commonality of Characteristics of Managed Volatility Portfolios

This article investigates the commonality in risk factors and sector biases in managed volatility equity strategies (both active and passive). A unique aspect of this article is that it is written from the perspective of a user of the strategies. Unlike all other past studies it considerers several versions of low volatility strategies—from different managers with different investment approaches and risk models. The findings here are therefore more general and not specific to a particular implementation or risk model. We will explore both actively managed volatility strategies as well as an index strategy.

Efficient Replication of Factor Returns, June 2009

We present alternative methods for constructing factor mimicking portfolios in practice. We illustrate how portfolios with a limited number of assets and relatively low turnover can be used to track pure factor returns. These portfolios provide an effective instrument to support the practice of investment management. We illustrate how they can be used to hedge out unintended factor exposures of a passive benchmark thus facilitating the optimal management of beta exposure. We illustrate how they can be used to hedge out unintended factor exposures of an active strategy thus isolating pure alpha and facilitating the management of alternative sources of alpha.