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HOW TO BE FACTOR AWARE: WHAT FACTORS ARE YOU EXPOSED TO

& HOW TO HANDLE EXPOSURE

LEARN2QUANT ZURICH & FRANKFURT

CHRISTOPH V. SCHON, CFA, CIPM

EXECUTIVE DIRECTOR, APPLIED RESEARCH

AXIOMA

MARCH 2018

Confidential – Not for Redistribution – Copyright © 2018 Axioma, Inc. 2

PRESENTATION OUTLINE

Understanding risk factors

• Types, examples and returns of factors

• “Factor-heavy” vs “alpha-rich” stocks

• Where factor analysis meets fundamental investing

• Benefits of factor awareness

• Incorporating factor strategies into fundamental investment process

Case study

• How to eliminate unwanted factor exposures from a fundamental portfolio in order to enhance

risk-return characteristics, based on “real-world” global fund

• Risk and performance attribution analysis, looking at split between systematic and specific risk

• Detailed examination of style factor contributions

• How to use portfolio optimizer to reduce factor exposures, while maintaining convictions

Further resources

3Confidential – Not for Redistribution – Copyright © 2018 Axioma, Inc.

UNDERSTANDING RISK FACTORS


TYPES OF FACTORS

Risk factors explain cross-sectional differences in performance

• E.g. small stocks expected to outperform large stocks

• Pure risk factors have no expected associated long-term return

• Alpha factors have an expected direction

• “Stock selection” or idiosyncratic risk is specific to an individual company apart from its risk

exposures

All alpha factors are risk factors, but not all risk factors are alpha factors


EXAMPLES OF RISK FACTORS

Factors Definition Theory Expected

Factor Return

Risk-based Investment Behaviors

Volatility 3 month average of absolute return

over cross-sectional standard deviation

Low risk stocks tend to

outperform high risk lottery tickets

Negative

Price-Reaction Based Factors

Momentum Total Return over the past 12 months,

excluding the most recent month

Investors underreact to good

news on medium term horizon

Positive

Growth & Value

Growth Sustainable growth rate, historical

earnings growth, historical sales growth

Stocks with sustainable earnings

growth tend to outperform

Positive

Value Book-to-price ratio, earnings-to-price

ratio

Cheap stocks outperform in the

long run

Positive

Other Characteristics

Size Natural logarithm of total issuer market

capitalization

Smaller stocks outperform large Negative


RISK FACTOR RETURNS

-100

-50

0

50

100

150

31/1

2/1

99

8

31/0

5/1

99

9

31/1

0/1

99

9

31/0

3/2

00

0

31/0

8/2

00

0

31/0

1/2

00

1

30/0

6/2

00

1

30/1

1/2

00

1

30/0

4/2

00

2

30/0

9/2

00

2

28/0

2/2

00

3

31/0

7/2

00

3

31/1

2/2

00

3

31/0

5/2

00

4

31/1

0/2

00

4

31/0

3/2

00

5

31/0

8/2

00

5

31/0

1/2

00

6

30/0

6/2

00

6

30/1

1/2

00

6

30/0

4/2

00

7

30/0

9/2

00

7

29/0

2/2

00

8

31/0

7/2

00

8

31/1

2/2

00

8

31/0

5/2

00

9

31/1

0/2

00

9

31/0

3/2

01

0

31/0

8/2

01

0

31/0

1/2

01

1

30/0

6/2

01

1

30/1

1/2

01

1

30/0

4/2

01

2

30/0

9/2

01

2

28/0

2/2

01

3

31/0

7/2

01

3

31/1

2/2

01

3

31/0

5/2

01

4

31/1

0/2

01

4

31/0

3/2

01

5

31/0

8/2

01

5

31/0

1/2

01

6

30/0

6/2

01

6

30/1

1/2

01

6

30/0

4/2

01

7

Cumulative Factor Returns

Value

Liquidity

Growth

Leverage

Volatility

Momentum

Size


EASILY BECOME FACTOR AWARE

Drive your research process into higher alpha-rich names using quant tools

Factor Heavy Alpha Rich


Earnings surprise from a factor point-of-view

• Company announces earnings that

surprise the street

• Analysts revise their earnings

projections

• Factor models pick up revisions in

projections and re-rate the

company’s fundamental factor scores

• Smart passive or active quant

investors buy/sell the stock as part of

their regular rebalancing activities

Growth Factor Score

0

10

20

30

40

50

60

70

80

90

100

50th to 80th Percentile

Earnings

Re-rating

WHERE FACTOR ANALYSIS MEETS FUNDAMENTAL INVESTING


BENEFITS OF FACTOR AWARENESS

• Avoid taking factor exposures that create long-term headwinds (e.g. volatility)

• Understanding which factors are overbought/oversold is another tool in the position sizing toolkit


INCORPORATE A FACTOR STRATEGY

Factor analysis is close to traditional fundamental investing

• The majority of factor information is already used by fundamental investors,

such as financial ratios

Quick adoption for fundamental managers familiar with factors

• Systematic integration helps fine-tune decision making on portfolio

construction & rebalancing

Factor-based portfolio analytics can be viewed as another tool

• Omega Point & Axioma provide a turnkey package that integrates with your

portfolio, automatically performing customized and scalable factor analysisCustomize

Manage

Analyze

Discover


CASE STUDY


AN ACTUAL “REAL-WORLD” PORTFOLIO

• Large, well-known global fund

• Fundamental manager who focuses on stock

selection

• Global portfolio, FTSE All-World Benchmark

• Portfolio has underperformed its benchmark

and had higher volatility

• Country, currency, & industry bets helped returns

-60%

-40%

-20%

0%

20%

40%

60%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Cumulative Returns

Active Portfolio Benchmark

Return Risk IR

Portfolio 3.58% 18.15%

Benchmark 3.86% 17.60%

Active -0.28% 2.63% -0.11


ATTRIBUTION BREAKS DOWN THE SOURCES OF A PORTFOLIO’S RETURNS

• “Specific” contribution for this portfolio

has been positive

• In other words, manager has

been a good stock picker

• “Factor” contribution has been negative

and created a drag on returns

• Style exposure more than offsets good

stock selection

• Country, currency, & industry bets

helped returns

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Return Contributions

Active Factor Contribution Specific Contribution


ATTRIBUTION DETAILS THE SOURCES OF THE PORTFOLIO’S RETURNS

• Portfolio has country, currency,

industry and style bets

• Country, currency and industry

bets paid off

• Style factors were the source of

the shortfall

• Positive exposure to volatility was

the biggest detractor

Source of Return Contribution Avg T-StatPortfolio 3.58%

Benchmark 3.86%

Active -0.28% -0.32

Specific Return 0.28% 0.44

Factor Contribution -0.56% -1.00

Axioma Style -1.37% -0.20 -3.38

Dividend Yield -0.25% -0.29 -2.37

Earnings Yield -0.03% -0.06 -0.86

Emerging Market Sensitivity -0.04% 0.01 -1.08

Exchange Rate Sensitivity -0.01% -0.01 -0.40

Growth -0.01% 0.12 -0.29

Leverage -0.08% -0.05 -1.93

Liquidity 0.04% 0.01 1.52

Market Sensitivity -0.08% 0.02 -0.59

Medium-Term Momentum -0.06% 0.03 -0.42

Profitability 0.05% 0.04 1.68

Size 0.21% -0.08 1.99

Value -0.15% -0.11 -2.26

Volatility -0.97% 0.17 -4.38

Country 0.11% 0.00 0.37

Industry 0.30% 0.00 0.97

Currency 0.40% 0.00 1.36

Local -0.01% 0.00 -1.49

Market 0.02% 0.00 1.06

Can we lower the factor,

particularly volatility,

exposure without changing

the nature of the portfolio?


OPTIMIZATION

Original Portfolio(not “risk aware”)

Optimized Portfolio

• Fewer names - eliminated those that were <25 bps

• Correlation of weights ~ 90%

• Same level of turnover

Portfolio reflects PM’s views without unintended bets!

• Minimize risk relative to original

• Only allow existing holdings

• Weights within 25 bps of original

• Reduce exposures to certain risk factors, aka “unintended bets”


OPTIMIZED RISK ANALYSIS

Predicted Active Risk Risk Breakdown

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010 2011 2012 2013 2014 2015

Percent of Active Variance – Fund

Specific

Factor

0%

20%

40%

60%

80%

100%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Percent of Active Variance – 25 bp - TO

Specific

Factor

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

Fund 25 bp - TO

• Predicted active risk falls

• Risk breakdown shifts from factor to specific


THE OPTIMIZED PORTFOLIO HAD BETTER ACTIVE RETURN AND ALMOST NO FACTOR CONTRIBUTION

-60%

-40%

-20%

0%

20%

40%

60% Cumulative Returns – Original Portfolio

-60%

-40%

-20%

0%

20%

40%

60%

80%Cumulative Returns – 25 bps TO

-5%

0%

5%

10%

15%Return Contributions – 25 bps

TO

-15%

-10%

-5%

0%

5%

10%Return Contributions – Original

Portfolio

Benchmark

Active

Portfolio

Specific

Contribution

Active

Factor

Contribution


OPTIMIZED PORTFOLIO’S RISK AND RETURN CHARACTERISTICS

Annualized Realized IR Comparison

Analytic Fund 25 bp - TO Change

Active -0.11 0.37 0.48

Specific 0.16 0.36 0.20

Factor -0.35 0.12 0.47

Axioma Style -1.12 -1.06 0.06

Country 0.12 0.18 0.06

Industry 0.31 0.76 0.45

Currency 0.39 0.25 -0.14

Annualized Realized Returns Comparison


Active -0.28% 0.76% 1.04%

Specific 0.31% 0.62% 0.31%

Factor -0.59% 0.14% 0.73%

Style -1.36% -0.43% 0.93%

Country 0.11% 0.09% -0.02%

Industry 0.29% 0.33% 0.04%

Currency 0.39% 0.17% -0.22%

Annualized Realized Risks Comparison


Active 2.63% 2.12% -0.51%

Specific 1.92% 1.87% -0.05%

Factor 1.69% 0.94% -0.75%

Axioma Style 1.21% 0.51% -0.70%

Country 0.88% 0.50% -0.38%

Industry 0.92% 0.55% -0.37%

Currency 0.87% 0.57% -0.30%

By making small changes to portfolio weights

we were able to get:

• Better active return with lower risk

• Higher specific return

• Factor return went from negative to positive

• All risks went down

• All IRs improved except currency


KEY TAKEAWAYS

• Factor models help managers understand sources of risk (predicted and realized) and returns

• Some factors are “compensated” and can be used in investment strategies (“smart beta”)

• Use factor models to discover hidden/unintended exposures

• Analyze factor returns and sensitivities to identify “headwinds” and “tailwinds”

• Focus on “alpha-rich” stocks

• Manage systematic risk and eliminate unwanted exposures (e.g. through optimization)

• Customize risk and portfolio construction tools to fit fundamental investment process


FURTHER RESOURCES

21Confidential – Not for Redistribution – Copyright © 2018 Axioma, Inc. 21

OMEGA POINT

Go to Omega Point website for further

information:

www.ompnt.com

22Confidential – Not for Redistribution – Copyright © 2018 Axioma, Inc. 22

AXIOMA RESEARCH INSIGHTS

Download research papers for free

from Axioma Research site:

http://axioma.com/insights/research/


QUESTIONS?

Christoph V. Schon, CFA, [email protected]+44 (0) 20 3621 8236

Or contact [email protected]

Copyright 2018. Axioma Inc. All rights reserved.

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confidential and proprietary to Axioma Inc. and its affiliates, are protected by

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or broadcast without the prior written permission of Axioma Inc.

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LEARN2QUANT ZURICH & FRANKFURTcom.estimize.public.s3.amazonaws.com/l2q presentations/4_l2q_zur… · • How to eliminate unwanted factor exposures from a fundamental portfolio in