Smart Beta Through the Lens of Risk Factors
Ben Meng and Paul Zhang
November 18, 2014
We analyze five popular smart beta indices with a simple two risk-factor framework. Our analysis shows that majority of the return variations of these five smart beta indices can be explained by S&P 500 and Barclays Treasury index. We also demonstrate that the diversification effect is limited by including the smart beta indices in an equity index portfolio with a metric called implied breath.

Fees Eat Diversification’s Lunch
William W. Jennings and Brian C Payne
December 26, 2014
Diversifying into more-exotic asset classes comes with different price tags. We consider investment management fees relative to various asset classes’ diversification benefit. We show that the fees on diversifying asset classes are astonishingly high relative to their diversification benefit. Diversification is often spoken of as the only free lunch in investing, yet we show that it is not free and is properly considered only in light of its costs. More-exotic asset classes typically come with higher investment management fees, which offset their diversification benefits. Because there is meaningful cross-sectional variation, fee levels need to be part of asset mix decisions and strategic asset allocation.

Tail Risk Protection in Asset Management
Cristian Homescu
November 11, 2014
Tail risk refers to the possibility that a rare event would adversely affect the value of a portfolio in a significant manner. It became much more relevant due to recent periods of strong market turbulence. We describe how to quantify such risk, which tail risk protection strategies were considered in the literature, their effectiveness and associated costs. We also review strategies that may be profitable,and thus can be used for more than just defensive purposes.

Better Investing Through Factors, Regimes and Sensitivity Analysis
Cristian Homescu
January 25, 2015
Recent periods of market turbulence and stress have created considerable interest in credible alternatives to traditional asset allocation methodologies. It would be preferred if portfolios can be decomposed into components that can be directly connected to independent risks and individually rewarded by the market for their level of risk. This can be achieved through factor-based investing, which relies on the observation that most return and risk characteristics for all asset classes can be well explained by particular building blocks, or factors. We describe main features of factors, factor investing and factor models, with emphasis placed on practical topics such as selection of significant factors associated to specific asset classes, differentiating between factors, anomalies or stylized facts, and preference for composite portfolios based on combining factors. We have also analyzed implementation details and the factor risk parity strategy. Then we consider improvements to factor-based investing through regime switching and sensitivity analysis. We present theoretical and practical frameworks for Markov switching models and for sensitivity analysis, and rely on representative examples to illustrate the benefits of efficiently incorporating regimes and sensitivity analysis into portfolio management. The final section describes features of good testing procedures for portfolio behavior and performance, in contrasts with possible testing pitfalls.

Facts and Fantasies About Factor Investing
Zélia Cazalet and Thierry Roncalli
October 2014
The capital asset pricing model (CAPM) developed by Sharpe (1964) is the starting point for the arbitrage pricing theory (APT). It uses a single risk factor to model the risk premium of an asset class. However, the CAPM has been the subject of important research, which has highlighted numerous empirical contradictions. Based on the APT theory proposed by Ross (1976), Fama and French (1992) and Carhart (1997) introduce other common factors models to capture new risk premia. For instance, they consequently define equity risk factors, such as market, value, size and momentum. In recent years, a new framework based on this literature has emerged to define strategic asset allocation. Similarly, index providers and asset managers now offer the opportunity to invest in these risk factors through factor indexes and mutual funds. These two approaches led to a new paradigm called ‘factor investing’ (Ang, 2014). Factor investing seems to solve some of the portfolio management issues that emerged in the past, in particular for long-term investors. However, some questions arise, especially with the number of risk factors growing over the last few years (Cochrane, 2011). What is a risk factor? Are all risk factors well-rewarded? What is their level of stability and robustness? How should we allocate between them? The main purpose of this paper is to understand and analyze the factor investing approach in order to answer these questions.