From the blog: With pension funds increasingly embracing risk factor investing, it is essential to ensure a factor premium is supported by empirical analysis, economic rationale and a simple factor definition.
It is daunting to conduct empirical analysis to establish which risk factors carry a reward. Researchers struggle to estimate expected returns, simply because they rely on very few data points: the starting price level and the end date price level.
This is also true for factor returns. As such, when testing whether a factor carries a premium, academic research conducts a thorough assessment, including the analysis of very long-term data across different regions and asset classes, and includes various corrections for possible data mining biases.
These studies are open to criticism and numerous papers are written to question previous empirical results. Consequently, academic research is much more capable of providing meaningful conclusions than a simple product backtest for a given factor index product.
Economic rationale
A factor premium should also be supported by a compelling economic rationale. The existence of factor premiums can be explained in two different ways – risk based and a behavioural bias.
The risk-based explanation’s premise is that the risk premium is compensation to investors who are willing to take additional risk by being exposed to a particular factor.
The behavioural explanation holds that the factor premiums exist because investors make systematic errors due to behavioural biases such as overreaction or underreaction to news on a stock.
If the risk premium can only be explained by behavioural reasoning, it is expected to disappear in the absence of limits to arbitrage.
A risk factor with a strong rational or risk-based explanation is more likely to continue to have a premium in the future. A risk-based explanation is therefore perhaps more reassuring for investors.
Finally, although transaction costs and other implementation issues such as turnover are mostly abstracted away when conducting such analyses, recent research addresses this shortcoming and confirms that the standard factors lead to rewards, even net of implementation considerations.
Straightforward adjustments to strategy design that make implementation easier lead to even more pronounced premiums net of transaction costs.
Felix Goltz is research director at index provider ERI Scientific Beta
