EXPERT OPINION J U LY 2 0 1 5

INVESTMENT INSIGHTS FROM LY XOR ASSET MANAGEMENT

COMBINING FACTORS IN A PORTFOLIO

Thierry Roncalli
Head of Quantitative Research
THE LIMITS OF ALPHA
Theres rapidly growing interest in
constructing equity portfolios by risk
factors, rather than by individual
geographical markets and sectors. But
how should factors be combined?
Franois Millet, Product Line Manager
for ETFs and Indexing at Lyxor Asset
Management and Thierry Roncalli,
Head of Quantitative Research, explore
Franois Millet the origins of factor investing and argue
Head of Product Line that a dynamic tactical allocation
Manager ETF & Indexing approach using factors promises
attractive risk-adjusted returns.
Alpha Falls as Number of Holdings Increases

Excess returnscollectively referred to as alpha are 80

earned by a portfolio manager in return for taking idiosyn- 70
cratic risk: in other words, picking stocks. But the more
diversified an equity portfolio becomes, the more difficult 60

it is to generate alpha. In practice, many portfolio mana- 50

gers own too many stocks as they are reluctant to risk
Alpha (in%)

too large a gap in performance against their index bench- 40

mark. By doing this, they severely reduce their chances of 30

adding value.
20 4F
There is plenty of evidence to support this claim. As long
ago as 1986, Brinson, Hood and Beebower calculated 10
that less than 10% of the average institutional portfo- 0
lios return is explained by security selection and market 0 10 3020 40 50 60 70 80 90 100
Number of stocks in the portofolio
timing. In a report published in 2009 on the performance *4F: Carharts Four Factor model (market beta, low size, value, momentum).
of the active managers of Norways Government Pension Source: Cazalet and Roncalli (2014)
Fund Global, Professors Ang, Goetzmann and Schaefer
stated that exposure to common risk factors contributed
over 99% of the funds past variation in returns, with active
>>I N B R I E F
risk contributing a tiny proportion.
>> M
 uch of the past performance of
More anecdotally, Warren Buffett famously said, if you
active managers can be explained by
can identify six wonderful businesses, that is all the diver-
exposure to common risk factors
sification you need.
So the greater the number of stocks you hold, the less >> F
 actors have played a key role in the
chance you have of generating alpha. If you use more than evolution of investment theory since
one factor to measure shared risks, the possibilities for the 1960s
alpha are even slimmer. >> D
 iversification across factors offers
an alternative to traditional portfolio
approaches.
>> A
 dynamic tactical allocation
exploits the tendency for short-term
persistence in factor returns.

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 EXPERT OPINION
INVESTMENT INSIGHTS FROM LY XOR ASSET MANAGEMENT
THE RISE OF SMART BETA
Over the last ten years, the way investors perceive the equity
markets has changed. Before, following the theoretical fra-
mework of the Capital Asset Pricing Model (CAPM), many
viewed investing as a simple dichotomy between beta and
alpha. An investor would allocate part of his or her portfolio to
an index-tracking fund to capture beta, the equity market risk
premium. The remainder of the portfolio would be delegated
to active managers in search of alpha.
But with the accumulation of evidence that much of the his-
torical performance of active managers can be explained by
exposure to alternative risk premia, there is growing demand
to access these premia by new, rules-based investment stra-
tegies. These are commonly referred to as smart beta. By
contrast with CAPM, a portfolio construction approach that
combines traditional beta, new betas and alpha can be des-
cribed as a risk factor asset allocation framework1.
Incorporating New Betas
Idiosyncratic Alpha
Risk
Alpha New
Other Risk Beta
premia
Market The Equity Market
Beta Risk Premium Beta
CAPM Risk Factor
framework
Source: Lyxor Asset Management
We dont want to downplay the role of alpha as it hasnt
disappeared. But alpha should be seen as the preserve of
portfolio managers who take truly idiosyncratic risks. Those
active managers who hold too many stocks and who are
reluctant to take bets will end up being displaced by smart
beta approaches, including factor portfolios.
(1) See the Lyxor Expert Opinions: Risk Factor Investing Explained
(October 2014); Combining Active and Passive Management in a Portfolio
(March 2015); Smart Beta: Broader Than you Think (May 2015).
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J U LY 2 0 1 5
FACTORS HELP US UNDERSTAND PORTFOLIOS
PERFORMANCE
We view smart beta as any rules-based strategy that does
not rely on the traditional approach of weighting portfolio
constituents by their market capitalisation. There has been
a sharp rise in inflows into smart beta funds in recent years:
European smart beta ETF assets quadrupled between the
end of 2013 and April 2015, for example.
Factor strategies are an important sub-category of smart
beta. As we mentioned earlier, there is a great deal of evi-
dence that much of the historical performance of active
managers can be explained by their exposure to common
risk factors, such as value, low size, momentum and qua-
lity. Factor strategies aim to capture such risk premia in a
transparent, rules-based manner.
But its also important to remember that the idea of factors
is not new. Since CAPM was first published by Treynor,
Sharpe, Lintner and Mossin in the early 1960s, academics
have introduced a number of theoretical modifications to
better explain the empirical performance of investment
portfolios. Common risk factors have played an important
role in these explanations for over twenty years.
Factors in the Evolution of Investment Theory
1961 - Treynor/Sharpe/Lintner/Mossin introduce CAPM
-1964 - Share performance = market risk + idiosyncratic risk
- Jensens alpha
1968 -A verage risk-adjusted mutual fund return is negative
after fees
- Malkiels Random Walk down Wall Street
1973 -A sset prices follow a random walk: persistent
outperformance is impossible
- Fama/French three-factor model
1992 -S tock returns explained by value and size factors
in addition to market beta
-C
 arharts On Persistence in Mutual Fund
1997 Performance
-A
 lpha of equity managers is not persistent if it is mea-
sured with respect to risk factors
Source: Lyxor Asset Management
 EXPERT OPINION J U LY 2 0 1 5

INVESTMENT INSIGHTS FROM LY XOR ASSET MANAGEMENT

LYXORS FACTOR FRAMEWORK PORTFOLIO ALLOCATION: FROM ASSETS TO FACTORS

Lyxors equity market factor framework focuses on those Traditionally, asset allocators have constructed portfolios
alternative risk premia that have solid theoretical support by diversifying across asset classes and, within individual
and which are backed by empirical evidence. In addition asset classes, diversifying across geographical markets,
to the market risk factor, the framework has five additional sectors and industries.
risk factors: the Fama-French factors of value and size, plus A factor-based allocation approach requires a rethink of
momentum, low beta and quality. this traditional method. But diversification across risk factor
The factor definitions we use are: strategies makes a great deal of sense, particularly since
Value: a composite of book-to-price, earnings yield the past correlation levels between individual factors have
and free cash flow yield been quite weak.
Low size: market capitalisation
Momentum: total return (with dividends reinvested)
over the last 12 months Low size Value Momentuml Low Beta Quality
Low beta: beta of the stock relative to its local 100%
Low size
market
Quality: a composite of total equity/net debt, return Value 52.7% 100%
on equity and net income/sales
Momentum 54.0% 19.7% 100%

Each Lyxor JP Morgan single factor index is constructed Low Beta 61.4% 15.8% 61.3% 100%
using a homogeneous approach. We calculate the factor
Quality 61.0% 37.1% 58.2% 54.9% 100%
score of each stock within a starting universe and standar-
dise it, before selecting a fixed number of stocks with the
highest factor score, typically around 10% of the original Source: Lyxor Asset Management, Richard and Roncalli (2015). Correlation
levels are measured using returns relative to the MSCI Europe Index, January
set. We then weight stocks equally within each factor index, 2000 - January 2015. Past performance is not a guide to future returns.
rebalancing the index monthly.
By adding the five new risk factors to the market risk factor Whether allocation across factors should be strategic or
used in CAPM, we are able to explain a greater proportion of tactical depends on investors time horizon and risk tole-
historical stock returns. For example, based on our analysis rance. Many large institutional investors are taking a long-
of past US equity portfolio returns, the six factors accounted term view of factors by embedding factor risk premia in the
for 90-100% of past performance, compared with as little as portfolio benchmark. For example, this was the recommen-
50% using a single factor model. dation of the authors of the study of the past performance
of Norways Government Pension Fund Global, the worlds
LYXORS EQUITY FACTOR FRAMEWORK
largest sovereign wealth fund.
Low Beta
o On the other hand, the performance of individual risk pre-
l
mia varies across market and economic cycles, generating
Value Quality
opportunities for investors interested in tactical allocation
Allocation
approaches.

Low Size Momentum

100

90

80
Common risk (in %)

70

60

50

40 *1F: market beta factor model. 6F: 6 factor model (market beta, low size,
1F model value, quality, low beta, momentum).
30 6F model Source: Cazalet and Roncalli (2014)
Source: Lyxor Asset Management, factor analysis of US equity portfolio
20 returns. Past performance is not a guide to future returns.
1995 2000 2005 2010 2015

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INVESTMENT INSIGHTS FROM LY XOR ASSET MANAGEMENT

BE LOCAL, NOT GLOBAL

Factor investing is best conducted on a local or regional
basis. If we implement the factor scoring process on a global
basis we tend to arrive at portfolios that are heavily concen-
trated in particular geographical markets. Also, the perfor-
mance of individual risk factor strategies has diverged across
different markets.
For example, the size factor has done well in the US, Europe
and Japan over the period since 2000, but has underperfor-
med in the Asia Pacific region. These performance differences
often reflect differences in market structure.

SIZE FACTOR RETURNS BY REGION

Asia Pacic Europe

110 110

100
100
90
90
80

70
80

60
70
50

40 60
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Japan North America

110 130

100 120

110
90
100
80
90
70
80

60 70

50 60
1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

Source: Lyxor Asset Management and Kenneth French data library. The charts show the returns of the Fama-French
SMB (Small Minus Big) factor in the respective geographical regions between 1995-2013 (1/1/95=100).

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 EXPERT OPINION J U LY 2 0 1 5

INVESTMENT INSIGHTS FROM LY XOR ASSET MANAGEMENT

A DYNAMIC FACTOR ALLOCATION APPROACH Based upon a recent analysis by Roncalli and Richard, using
As can be seen from a heat map of factor performance since a back-test of Lyxors factor framework and European equity
2008, there has been a substantial variation in the returns of market returns from 2000-2014, this so-called Active Risk
individual factors. Individual factors have also shown quite Parity (ARP) approach to factor allocation contributed 7% a
volatile performance: value, for example, was the best- year in excess returns to the market portfolio and with lower
performing factor across European equities in 2009, 2012 historical volatility. The ARP approach had a modestly higher
and 2013, but the worst-performing in 2008, 2010 and 2011. maximum historical drawdown than the market portfolio
over that period.
This variation of course argues for a diversified approach
to factor investing. But Thierry Roncalli and Jean-Charles
Richard, quantitative researchers at Lyxor, have also identified Active RiskParity
Market Equally-weighted
(ARP)
an interesting fact: unlike asset class returns, risk factor returns
Return 1.8 7.6 8.9
exhibit some persistence over the short term. In other words,
Volatility 20.2 18.2 16.9
how individual factors performed over the previous month or
months has a significant chance of predicting performance Sharpe ratio 0.0 0.3 0.4

over the next month. Excess return 5.8 7.0

Tracking error 8.4 8.9

A good starting point for a long-term, strategic allocation
Information ratio 0.7 0.8
to factors is to use an equal risk contribution approach:
individual factor weights are calculated on a monthly basis Max. drawdown -58.5 -65.7 -63.2

so as to contribute equally to the volatility of the overall Best month 14.2 17.6 15.8

factor portfolio. Worst month -13.8 -17.9 -17

Correlation 90.9 90.2

For investors wishing to add value, a dynamic tactical
Beta 0.8 0.8
allocation approach exploits the tendency for the short-
Turnover (2x) 0.1 1.3
term performance of risk factors to persist. By incorporating
short-term expected returns into the asset allocation we can Source: Lyxor Asset Management, Richard and Roncalli (2015). MKT=market
improve on the expected risk-adjusted return of the factor factor portfolio, EW=equally weighted factor portfolio, ARP=Active Risk Parity
factor portfolio. Underlying market factor is the MSCI Europe index net total
allocation2. return. Returns are measured from January 2000-December 2014. Past
performance is not a guide to future returns.

Factor Performance Heat Map

2008 2009 2010 2011 2012 2013 2014

Low Beta-41.0% Value76.1% Quality23.3% Low Beta-2.2% Value32.8% Value30.5% Size10.7%

Momentum-41.3% Size45.9% Momentum22.7% Quality-4.6% Quality24.2% Momentum29.8% Quality8.6%

Market-43.6% Quality40.1% Low Beta18.0% Market-8.1% Momentum24.0% Size25.0% Low Beta8.1%

Size-47.1% Market31.6% Size17.7% Momentum-9.1% Market17.3% Quality20.2% Value7.0%

Quality-55.4% Momentum22.3% Market11.4% Size-23.3% Low Beta15.8% Market19.8% Market6.8%

Value-68.6% Low Beta18.8% Value1.1% Value-31.0% Size4.8% Low Beta17.0% Momentum5.2%

Ref. 631211 228220 Studio Socit Gnrale +33 (0)1 42 14 27 05 06/2015

(2)See Thierry Roncalli (2014), Introducing expected returns into risk parity portfolios: a new framework for asset allocation, Lyxor research paper
Lyxor Asset Management, Richard and Roncalli (2015), market factor is the MSCI Europe index net total return. Past performance is not a guide to
future returns.
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