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Diversify and Purify Factor Premiums in Equity Markets

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “Diversify and Purify Factor Premiums in Equity Markets” addresses the challenge of effectively capturing factor premiums in equity markets, such as value, quality, low risk, and momentum factors.

Examining a range of portfolio construction approaches that focus on maintaining adequate risk control, the paper aims to increase information ratios. Maximizing factor strategies involves targeting constant volatility over time, hedging market beta and the size factor. Neutralizing sector exposures is particularly important for the value and low risk factors.

Furthermore, long-only strategies are found to be efficient alternatives for capturing factor premiums. Lastly, although factor premiums exhibit fatter tails than what would be expected from a Gaussian distribution of returns, skewness is not significantly negative in most cases.

Abstract Of Paper

In this paper we consider the question of how to improve the efficacy of strategies designed to capture factor premiums in equity markets and, in particular, from the value, quality, low risk and momentum factors. We consider a number of portfolio construction approaches designed to capture factor premiums with the appropriate levels of risk controls aiming at increasing information ratios. We show that information ratios can be increased by targeting constant volatility over time, hedging market beta and hedging exposures to the size factor, i.e. neutralizing biases in the market capitalization of stocks used in factor strategies. With regards to the neutralization of sector exposures, we find this to be of importance in particular for the value and low risk factors. Finally, we look at the added value of shorting stocks in factor strategies. We find that with few exceptions the contributions to performance from the short leg are inferior to those from the long leg. Thus, long-only strategies can be efficient alternatives to capture these factor premiums. Finally, we find that factor premiums tend to have fatter tails than what could be expected from a Gaussian distribution of returns, but that skewness is not significantly negative in most cases.

Original paper – Download PDF

Here you can download the PDF and original paper of Diversify and Purify Factor Premiums in Equity Markets.

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Author

Raul Leote de Carvalho
BNP Paribas Asset Management

Lu Xiao
BNP Paribas Investment Partners

François Soupé
BNP Paribas Asset Management

Patrick Dugnolle
BNP Paribas – BNP Paribas Asset Management

Conclusion

In conclusion, the research paper highlights the importance of enhancing strategies designed to capture factor premiums, focusing on value, quality, low risk and momentum factors. By examining various portfolio construction approaches and implementing appropriate risk controls, information ratios can see a significant increase.

Targeting constant volatility, hedging market beta and size factor exposures, and neutralizing biases in market capitalization all contribute to improved outcomes. Moreover, careful neutralization of sector exposures proves especially crucial for value and low risk factors.

The paper also emphasizes that long-only strategies are often more efficient alternatives in capturing factor premiums compared to shorting stocks, and that factor premiums generally have fatter tails in return distributions with no significant negative skewness. Adopting such approaches can greatly impact the effectiveness of factor investing in equity markets.

Related Reading:

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Global Return Premiums on Earnings Quality, Value, and Size

FAQ

Q1: What is the main focus of the research paper “Diversify and Purify Factor Premiums in Equity Markets”?

The research paper addresses the challenge of effectively capturing factor premiums in equity markets, specifically focusing on factors like value, quality, low risk, and momentum. It explores various portfolio construction approaches with an emphasis on maintaining adequate risk control to enhance information ratios.

Q2: How does the paper suggest improving the efficacy of strategies designed to capture factor premiums, and what are the key factors considered for risk control?

The paper suggests increasing information ratios by targeting constant volatility over time, hedging market beta, and neutralizing exposures to the size factor. It emphasizes the importance of neutralizing biases in market capitalization and particularly highlights the significance of neutralizing sector exposures, especially for the value and low-risk factors.

Q3: What does the research reveal about the efficiency of long-only strategies in capturing factor premiums, and how does it compare to shorting stocks in factor strategies? The paper finds that, with few exceptions, contributions to performance from the short leg are inferior to those from the long leg. As a result, long-only strategies are considered efficient alternatives for capturing factor premiums compared to shorting stocks.

Q4: What insights does the paper provide regarding the distribution of factor premiums in return distributions, and what is the significance of skewness in most cases?

The research reveals that factor premiums tend to have fatter tails than expected from a Gaussian distribution of returns. However, the paper emphasizes that skewness is not significantly negative in most cases.

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