Ch 7: Factors

Prof Roelof Salomons

February 2016
 Outline

What is a factor?

Macro factors

Dynamic factors

Fama-French

Value-growth

Size

Momentum

2
What is a factor?
 What is a Factor?

A systematic factor is a variable that affects the returns of all assetsit is only
a question of degree as to how a particular asset is affected

Factors can be

Fundamental or macro, which are usually non-tradable (at least not in

scale)

Investment or tradable

Exposure to factor risk earns a risk premium. Because of general risk aversion
in the economy, investors require a positive risk premium to be exposed to
assets which lose, on average, when factor realizations are high. For example,
assets which tend to have low returns when inflation is high are risky, and so
over the long run earn an inflation risk premium.

4
Macro Factors
Economic Growth

Average Returns
18%

16%

14%

12%

10%
Full Sample
8% Recessions
6% Expansions
4%

2%

0%
Large Stocks Small Stocks Govt Bonds Corp Bonds Corp Bonds
Inv Grade High Yld

6
Economic Growth

Volatilities
40%

35%

30%

25%
Full Sample
20%
Recessions
15%
Expansions
10%

5%

0%
Large Stocks Small Stocks Govt Bonds Corp Bonds Corp Bonds
Inv Grade High Yld

7
 Economic Growth

US equities have closely tracked economic growth surprises well

Exhibit 14.4 from Ilmanen

8
 Economic Growth

Growth factor = monthly change in consensus forecast of next-year U.S. real GDP
growth

Most asset classes are positively exposed to growth news; long Treasury positions
and momentum-oriented strategies are the main exception

Exhibit 14.7 from Ilmanen

9
Inflation

Average Returns
20%
18%
16%
14%
12%
Full Sample
10%
Low
8%
High
6%
4%
2%
0%
Large Stocks Small Stocks Govt Bonds Corp Bonds Corp Bonds
Inv Grade High Yld

10
Inflation

Volatilities
30%

25%

20%

Full Sample
15%
Low
10% High

5%

0%
Large Stocks Small Stocks Govt Bonds Corp Bonds Corp Bonds
Inv Grade High Yld

11
 Inflation

Inflation factor = monthly change in consensus forecast of next-year U.S. inflation rate
(Consensus Economics)

Commodity futures have benefited most from rising inflation expectations while
Treasury positions suffer

Exhibit 15.7 from Ilmanen

12
Volatility

VIX and One-Year Moving Average of Stock Returns

0.8 1
VIX (LH axis)
S&P500 Returns (RH axis)

0.6 0.5

Stock Returns
VIX

0.4 0

0.2 -0.5

0 -1
1990 1995 2000 2005 2010

13
 Other Macro Factors

Productivity

Demographic risk

Political risk

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Investment Factors
 Simple Investment Factors

Equities

Bonds

Cheap index management delivers these long-only factors at essentially zero

cost in very large size

Based on market capitalization weightsrepresent the aggregate average

investor

16
Dynamic Factors
 Dynamic Factors

Theory and long investing experience have identified classes of assets that
have consistently higher (or lower) average returns than the market portfolio

Dynamic factors take long position in securities with similar characteristics,

which tend to comove with each other, and offsetting short positions in
securities with the opposite characteristics

The market portfolio, by definition, has no dynamic factor exposure

The average investor, who holds the market, does not practice dynamic factor
investing!

18
 Dynamic Factors

Classics

Value-Growth Premium = Value stocks minus growth stocks

Size Premium = Small stocks minus large stocks

Momentum Premium = Winning stocks minus losing stocks

Others

Illiquidity Premium = Illiquid securities minus liquid securities

Credit Risk Premium = Securities with high default risk minus securities with
low default risk

Low Volatility Risk Premium = Stocks with low volatility minus stocks with high
volatility

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 Value vs Growth

Value vs Growth
20

15

10

MKT
Value
Growth

0
1927 1937 1947 1957 1967 1977 1987 1997 2007

-5

20
 Small vs Large

Small vs Large
20

15

10

MKT
Small
Large

0
1927 1937 1947 1957 1967 1977 1987 1997 2007

-5

21
 Winners vs Losers

Winners vs Losers
20

15

10

MKT
Winners
Losers

0
1927 1937 1947 1957 1967 1977 1987 1997 2007

-5

22
 Dynamic Factors

Investing in dynamic factor strategies requires skills, and is costly

Factor risk premiums do not come for free

Similar to collecting insurance premiums

23
 Going Beyond Asset Classes

Value

Fixed Income: Riding the yield curve or Roll-down related to duration

Foreign Exchange: Carry

Equities: Value/Growth

Commodities: Roll related to normalization/backwardation

Momentum

Equities, Fixed Income, Foreign Exchange: Momentum

Commodities: CTA

Also called Trend

24
 Fixed Income Factors

Cumulated Returns on Fixed Income Factors

120.0

100.0

Term
80.0
CreditAa
60.0
CreditBaa

40.0
CreditHY

20.0

0.0
1998 2000 2002 2004 2006 2008 2010 2012 2014

-20.0

-40.0

-60.0

-80.0

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 Equity Factors

Cumulated Returns on Equity Factors

160.0

140.0
ValGrth
120.0
SmLg

100.0 Mom

LowVol
80.0
SellVol
60.0

40.0

20.0

0.0
1998 2000 2002 2004 2006 2008 2010 2012 2014

-20.0

-40.0

-60.0

26
Fama-French
 Dynamic Factors

Sort stocks into deciles based on

Size

Book/Price (measure of value)

Past 12-month return

Use data 1927:01 to 2013:12

28
 Risk and Return
40

35

30
Mean/Stdev (%)

25

20 Mean
Stdev
15

10

0
Market Small 1 Large 10 Growth 1 Value 10 Losers 1 Winners 10

29
 Dynamic Factors

We can use factor benchmarks with dynamic factors, which involve long-short
positions in different portfolios with opposite characteristics (value vs growth,
small vs large, winner vs loser, etc)

The same intuition as the simple factor benchmark holds: the factors represent
returns that an investor could receive from holding that factor

To receive the factor premium, the investor takes both long and short
positions

Consider two dynamic factors

Small minus large

Value minus growth

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 Fama-French

Fama and French (1993)

Includes a small and value factor in addition to the market factor (MKT)

SMB = small minus big stocks

HML = high book/price (value) minus low book/price (growth)

E[ri ] rf bi , MKT E[rm - rf ] bi , SMB E[SMB] bi , HML E[ HML]

Fama and French interpret the small stock effect and the value effect as being
systematic factors.

SMB and HML are zero-cost portfolios, so bi,SMB and bi,HML are centered around
zero

Extension of CAPM to size effect and value effect

31
 Value vs Growth

Value Stocks: Stocks that are out of favor with the investment community
selling at relatively low prices in relation to their earnings or book value. These
stocks typically produce above-average dividend income.

Growth Stocks: Stocks of companies with above-average prospects for growth

based on measures like revenue, earnings and book value. These stocks
generally produce little dividend income and tend to trade at high prices relative
to earnings or book value.

32
 Dynamic Factor Benchmarks

The SMB and HML factors are zero cost:

SMB = $1 in small stocks minus $1 in large stocks

HML = $1 in value stocks minus $1 in growth stocks

A fund manager specializing in small stocks has a +ve loading on SMB, and a
fund manager tilting towards value stocks has a +ve loading on HML

A common addition is a long-short momentum factor UMD or MOM originally

due to Carhart (1997)

The alpha is the risk-adjusted return or the excess return. It is the unique
return generated by the manager in excess of what could be done
mechanically through passive exposures to factors.

Dynamic factors assume you can short! If you cant, you must use simple
factor benchmarks with positivity constraints.

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Fama-French (1993)

Returns to the SMB and HML Strategies

14
SMB
HML
12

10
Value of $1 Invested

0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

34
Jegadeesh-Titman (1993) Momentum

Returns to the SMB, HML and WML Strategies

70
SMB
HML
60
WML

50
Value of $1 Invested

40

30

20

10

0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

35
Value-Growth
 Value vs Growth

Value vs Growth
20

15

10

MKT
Value
Growth

0
1927 1937 1947 1957 1967 1977 1987 1997 2007

-5

37
 CAPM to Multifactor Models

More generally, we can view the risk premium in the CAPM for covarying with
bad times, where bad times are defined by low returns of the market portfolio

High covariances with rm = low covariances with +rm (low beta) => low risk
premium

To summarize, if the payoff of an asset tends to be

High in bad times => valuable asset to hold => low returns

Low in bad times => high returns

In a multi-factor model, bad times are defined by more than low returns of just
one factor

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 Risk and Return

To summarize, if the payoff of an asset tends to be

High in bad times => valuable asset to hold => low returns

Low in bad times => high returns

Any rational story of a strategy having unconditionally high expected returns is

those high expected returns compensate the investor for losing money during
bad times.

Applied to value investing:

Value stocks have high expected returns because they are risky during bad
times. Value stocks tend to lose money during bad times and require high risk
premia to induce investors to hold these stocks.

Growth stocks have low returns because they tend to pay off during bad times
and are less risky.

39
 Time-Varying Betas

Lettau and Ludvigson (2001) advocate a conditional CAPM, where value

stocks betas become higher during bad times when expected returns on the
market are high and prices are low

As betas are high, there are potentially more losses holding value stocks
during bad times

Significant time variation of value firm betas

40
Time-Varying Betas

Value-Growth Betas from Ang and Kristensen (2012)

41
 Long-Run Risk

Bansal et al. (2005) measure bad

times using long-run (backward-
looking) averages of consumption
growth. This is long run
consumption risk.

Value stocks have higher betas

with respect to long-run
consumption growth than higher
frequency consumption growth

42
 Real Investment Risk

In Zhang (2005), adjustment costs are

asymmetric and firms face higher costs in
adjusting capital stocks downward

Value firms are risky because during bad times

They are burdened with more unproductive

capital (they cannot disinvest as easily as
growth firms because they hold stodgy
PP&E).

They want to cut back on capital, face

higher adjustment costs

Thus they are riskier than growth firms

Figure 1 from Zhang (2005)
Growth firms can better deal with a downturn
by deferring investment

43
 Behavioral Theories: Over-Extrapolation

Most behavioral explanations of value center around over-reaction/over-extrapolation

Investors over-extrapolate past growth rates into the future.

Growth firms have had high past growth rates. Prices of these firms are bid up too
high reflecting excessive optimism.

When growth does not materialize, prices fall so returns are low relative to value
firms

Value stocks are NOT fundamentally riskier

Story first put forward by Lakonishok, Shleifer and Vishny (1994)

Crucial assumption: nave investors over-extrapolate and prices reflect the over-
reaction. Contrarian (value) investors outperform by taking the opposite side.

Why dont more value investors enter the market and bid up the prices of value
stocks removing the value premium?

44
 LSV compare actual growth rates to
past growth rates and to expected
growth rates implied by firm multiples
in Table 5

Panel A: value portfolios have higher

fundamentals to price ratios

Panel B: growth stocks grew

substantially faster than value stocks
5 years prior to portfolio formation

Panel C: In the 5 years post

formation, growth rate for growth
stocks are lower than 5 years
previously, and lower than value
stocks. Especially low growth over
years +2 to +5.

45
Size
 Small vs Large

Small vs Large
20

15

10

MKT
Small
Large

0
1927 1937 1947 1957 1967 1977 1987 1997 2007

-5

47
Fama-French

Cumulative Returns to the SMB and HML Strategies

3
SMB
HML
2.5

1.5

0.5

0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year

48
Fama-French

Cumulative Returns to the Market-Adjusted SMB and HML Strategies

3
SMB
HML
2.5

2
Value of $1 Invested

1.5

0.5

0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year

49
 Small-Large

Was it spurious?

Consistent with the actions of a near-efficient market

50
Momentum
 Winners vs Losers

Winners vs Losers
20

15

10

MKT
Winners
Losers

0
1927 1937 1947 1957 1967 1977 1987 1997 2007

-5

52
 Origins of Momentum Matter

Rational Theories

The payoff to momentum is a payoff for bearing systematic risk

Implication: Eventually the risk will materialize

Momentum contains information generated by hard-working investors that is not yet

fully discounted by market prices
Implication: If the information is correct, momentum investing will yield positive
returns

Behavioral Theories

Investors make systematically irrational decisions by over-extrapolating price

movements
Implication: Invest in momentum, but jump off at the right time

They under-react to important information

Implication: If so, buy past winners and sell past losers. As investors adjust to the
information, you will profit

53
 Risk Theories

Momentum is hard to explain with a risk story. But, there seem to be some risk
components of momentum profits

Momentum profitability varies over the business cycle

Momentum strongest during bull markets (this is also consistent with over-
reaction)

There are downside risk components to momentum profits

Links to liquidity risk

54
 Momentum Reversals

Jegadeesh and Titman (2001) track the returns of momentum portfolios up to 5 years
post-formation

Momentum profits reverse in years 2-5.

55
 Behavioral Theories

Behavioral explanations of momentum come in two main flavors:

Under-reaction: good news comes out but investors under-react. Then,

prices slowly drift upwards to the rational price.

Over-reaction: irrational investors over-react to positive news. This over-

reaction is gradual, so stock prices display momentum for a period of time
but then eventually reverse and return to fundamental value.

Most combine elements of under- and over-reaction

The under-reaction captures momentum, while the over-reaction captures long-

term mean reversion

56
 Behavioral Theories

Barberis, Shleifer and Vishny (1998): Under-reaction

Uses two psychological biases

Conservatism: Investors underreact to information because they stick to

their prior beliefs. This causes momentum.

Representative heuristic: investors mistakenly conclude that firms with high

earnings growth in the past continue to experience high earnings growth in
the future. Representativeness causes investors to assume commonality
between similar objects (here past and future growth rates).
Representativeness leads to long-term mean reversion.

No role for any rational investors

57
 Behavioral Theories

Hong and Stein (1999): Under-reaction

No behavioral biases

Two groups of investors, both rational but have limited information sets (bounded
rationality)

Informed investors (news watchers) receive signals of firm value but ignore
information in the past history of prices

Uninformed investors (momentum traders) do not receive signals but trade

based only on past prices

Information received by informed investors is transmitted with a delay and is only

partially incorporated in prices when first revealed to the market. Momentum traders
jump on the train. This leads to under-reaction and momentum.

Momentum traders push prices past fundamental values. Reversals obtain when
prices eventually revert to fundamentals.

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Summary
 Summary

Factors can be both fundamental, like macro factors like economic growth and
inflation, and investment (or style) factors, like value-growth, size, and
momentum

Factors can have both rational (risk-based) or behavioral foundations. Many

factors, such as value-growth, can have both explanations.

60