Factor Investing Slides

Summary
Empirical Evidence of Risk Factors

From Risk Factors to Factor Investing
Asset Allocation with Risk Factors
Factor Investing and Equity Portfolio Construction1
Thierry Roncalli?
?
Lyxor Asset Management, France
Amsterdam, January 2015
1 The
materials used in these slides are taken from Cazalet Z. and Roncalli T. (2014),
Facts and Fantasies About Factor Investing, Lyxor Research Paper, 116 pages.
Thierry Roncalli Factor Investing and Equity Portfolio Construction 1 / 114
Summary
Lyxor Research Paper
http://ssrn.com/abstract=2524547
Summary
Outline
3 From Risk Factors to Factor

1 Summary Investing
From risk factors to factor Factor indexes
investing Long/short vs long-only
Factor zoo portfolios
Facts and fantasies Capacity
2 Empirical Evidence of Risk 4 Asset Allocation with Risk

Factors Factors
SMB, HML and WML A magical world?
Volatility Optimal allocation
Other risk factors Robustness

Summary
From risk factors to factor investing
Factor zoo
Facts and fantasies
Risk factors versus factor investing
Risk factor
It is a pattern that explains the cross-section of asset returns and that will
explain the cross-section of asset returns in the future.
Risk factors were initially based on systematic and common risks. They
embed now other dimensions, such as anomalies or trading strategies.
Risk factors are one of the pillars of performance measurement (Carhart,

1997).

Summary
Factor zoo
Facts and fantasies
Risk factors versus factor investing
Factor investing (marketing message)

Strategic asset allocation based on asset classes is an issue, because:
it is difficult to estimate their risk premia;
correlations between asset classes are time-varying and not stable;
we dont know if it is the right level of aggregation.
Asset classes are exposed to independent risk factors, which are rewarded
on the long-run, meaning that strategic asset allocation based on risk
factors is more easy and robust.
Factor investing consists in:

building factor mimicking portfolios (asset management & index
providers);
allocating between risk factors (investors).

Summary
Factor zoo
Facts and fantasies
What is the rationale for factor investing?
At the security level, there is a lot of idiosyncratic risk or alpha:

Common Idiosyncratic
Risk Risk
GOOGLE 47% 53%
NETFLIX 24% 76%
MASTERCARD 50% 50%
NOKIA 32% 68%
TOTAL 89% 11%
AIRBUS 56% 44%

Summary
Factor zoo
Facts and fantasies
Idiosyncratic risk decreases with the size of the investment portfolios:

Common Idiosyncratic
Portfolio
Risk Risk
Renaissance Europe 69.2% 30.8%
Threadneedle Pan European SC 87.5% 12.5%
Franklin Mutual European 90.2% 9.8%
SG Actions Euro Value 91.7% 8.3%
Metropole Selection 91.8% 8.2%
Allianz Europe Equity Growth 92.0% 8.0%

Summary
Factor zoo
Facts and fantasies
2009: Professors Report on the Norwegian GPFG (Ang, Goetzmann

and Schaefer) Risk factors represent 99.1% of the fund return
variation
What lessons can we draw from this?

Idiosyncratic risks and specific bets disappear in (large) diversified
portfolios. Performance of institutional investors is then exposed to risk
factors.
Alpha is not scalable, but risk factors are scalable.
Risk factors are the only bets that are compatible with diversification.
Is that really true?

Summary
Factor zoo
Facts and fantasies
The cross-section of expected returns
Cross-section of expected returns

The objective is to explain the dispersion of asset returns at time t (not
the time-variation).
10 value-weighted (or equally-weighted) sorted portfolios (by deciles)
25 VW/EW sorted portfolios
e.g. independent sorts into 5 size groups and 5 B/M groups
Universe of stocks
Two statistical tools are used:

t-stat (are asset returns sensitive to the factor?)
R 2 (how many variance is explained?)
If XMY (e.g. HML) is a risk factor, -XMY (e.g. LMH) is a risk factor.

Summary
Factor zoo
Facts and fantasies
Risk premium versus risk premia
CAPM
There is one risk premium, which can be captured by the market portfolio.
Factor investing
There are other risk premia than the market risk premium. They
correspond to rewarded risk factors.
If XMY (e.g. HML) is a risk premium, -XMY (e.g. LMH) is not a risk
premium.
XMY is a risk premium XMY is a risk factor.
XMY is a risk factor ; XMY is a risk premium.

Summary
Factor zoo
Facts and fantasies
Risk factors and anomalies

' $
HML Factor
(Value Strategy)
Q
Q
Q
Q
+
s
Q
Aggressive Portfolio Defensive Portfolio
? ?
Distressed Risk Quality Stocks
(Fama and French, 1998) (Piotroski, 2000)
? ?
2008 Financial Crisis Dot.com bubble
& %

Summary
Factor zoo
Facts and fantasies
Factor zoo
Figure: Harvey et al. (2014)
Now we have a zoo of new factors (Cochrane, 2011).

Summary
Factor zoo
Facts and fantasies
Factors, factors everywhere
Standard predictive regressions fail to reject the hypothesis that

the party of the U.S. President, the weather in Manhattan,
global warming, El Nio, sunspots, or the conjunctions of the
planets, are significantly related to anomaly performance. These
results are striking, and quite surprising. In fact, some readers
may be inclined to reject some of this papers conclusions solely
on the grounds of plausibility. I urge readers to consider this
option carefully, however, as doing do so entails rejecting the
standard methodology on which the return predictability
literature is built.(Novy-Marx, 2014).
MKT, SMB, HML, WML, STR, LTR, VOL, IVOL, BAB, QMJ, LIQ,
TERM, CARRY, DIV, JAN, CDS, GDP, INF, etc.

Summary
Factor zoo
Facts and fantasies
The alpha puzzle (Cochrane, 2011)

Chaos
E [Ri ] Rf = i
Sharpe (1964)
E [Ri ] Rf = im (E [Rm ] Rf )
Chaos again
E [Ri ] Rf = i + im (E [Rm ] Rf )
Fama and French (1992)
E [Ri ] Rf = im (E [Rm ] Rf ) + ismb E [Rsmb ] + ihml E [Rhml ]
This is not the end of the story...

Summary
Factor zoo
Facts and fantasies
The alpha puzzle (Cochrane, 2011)

Its just the beginning!
Chaos again
E [Ri ] Rf = i + im (E [Rm ] Rf ) + ismb E [Rsmb ] + ihml E [Rhml ]
Carhart (1997)
E [Ri ]Rf = im (E [Rm ] Rf )+ismb E [Rsmb ]+ihml E [Rhml ]+iwml E [Rwml ]
Chaos again
E [Ri ] Rf = i + im (E [Rm ] Rf ) + ismb E [Rsmb ] +
ihml E [Rhml ] + iwml E [Rwml ]
Etc.
How can alpha always come back?

Summary
Factor zoo
Facts and fantasies
Facts and fantasies
Main fact
Risk factors are a powerful tool to understand the cross-section of
(expected) returns.

Summary
Factor zoo
Facts and fantasies
Facts and fantasies

Fact
Common risk factors explain more variance than idiosyncratic risks in
diversified portfolios.
Some risk factors are more relevant than others, for instance SMB,
HML and WML.
Risk premia are time-varying and low-frequency mean-reverting. The

length of a cycle is between 3 and 10 years.
The explanatory power of risk factors other than the market risk
factor has declined over the last few years, because Beta has been
back since 2003.
4
Summary
Factor zoo
Facts and fantasies
Facts and fantasies
Fact
Long-only and long/short risk factors have not the same behavior.
This is for example the case of BAB and WML factors.
Risk factors are local, not global. It means that risk factors are not
homogeneous. For instance, the value factors in US and Japan cannot
be compared (distressed stocks versus quality stocks).
Factor investing is not a new investment style. It has been largely

used by asset managers and hedge fund managers for a long time.

Summary
Factor zoo
Facts and fantasies
Facts and fantasies
Main fantasy
There are many rewarded risk factors.

Summary
Factor zoo
Facts and fantasies
Facts and fantasies

Fantasy
Risk factors are not dependent on size. It is a fantasy. Some risk
factors present a size bias, like the HML risk factor.
HML is much more rewarded than WML.
WML exhibits a CTA option profile. This is wrong. The option profile
of a CTA is a long straddle whereas WML presents some similarities
to a short call exposure.
Long-only risk factors are more risky than long/short risk factors.
This is not always the case. For instance, the risk of the long/short
WML factor is very high.
8
Summary
Factor zoo
Facts and fantasies
Facts and fantasies
Fantasy
HML is riskier than WML. It is generally admitted in finance that
contrarian strategies are riskier than trend-following strategies.
However, this is not always the case, such as with the WML factor,
which is exposed to momentum crashes.
Strategic asset allocation with risk factors is easier than strategic

asset allocation with asset classes. This is not easy, in particular in a
long-only framework. Estimating the alpha, beta and idiosyncratic
volatility of a long-only risk factor remains an issue, implying that
portfolio allocation is not straightforward.
8
Summary
SMB, HML and WML
Volatility
Other risk factors
Fama-French risk factors

Fama-French three-factor model
We have:
E [Ri ] Rf = im (E [Rm ] Rf ) + ismb E [Rsmb ] + ihml E [Rhml ]
where Rsmb is the return of small stocks minus the return of large stocks,
and Rhml is the return of stocks with high book-to-market values minus
the return of stocks with low book-to-market values.
The factors are defined as follows:
1 1
SMBt = (Rt (SV) + Rt (SN) + Rt (SG)) (Rt (BV) + Rt (BN) + Rt (BG))
3 3
1 1
HMLt = (Rt (SV) + Rt (BV)) (Rt (SG) + Rt (BG))
2 2
with the following 6 portfolios:
Value Neutral Growth
Small SV SN SG
Big BV BN BG
Summary
SMB, HML and WML
Volatility
Other risk factors
Dynamics of the three risk factors
Figure: Fama-French US risk factors (1930 - 2013)

Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Fama-French SMB factor (1995 2013)

Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Fama-French HML factor (1995 2013)

Summary
SMB, HML and WML
Volatility
Other risk factors
The cross-section of asset returns

Cross-section = 100 value-weighted portfolios (independent sorts into 10
size groups and 10 B/M groups
Figure: R 2 coefficient (in %) US

Summary
SMB, HML and WML
Volatility
Other risk factors

2 2
Table: Average of RFF RCAPM (in %)
Year Asia Pacific Europe Japan North America US
1995 12.1 13.7 10.0 17.9 18.0
1996 11.7 14.4 9.8 22.5 23.0
1997 12.7 17.6 11.1 22.4 20.2
1998 13.0 19.1 14.0 21.1 18.4
1999 12.8 19.9 15.2 19.2 19.2
2000 13.1 27.2 20.4 29.5 31.6
2001 13.0 26.4 21.1 30.3 36.1
2002 12.3 23.4 20.9 28.6 35.0
2003 13.3 20.3 19.4 27.3 34.4
2004 13.5 17.5 19.3 27.1 33.2
2005 11.5 11.6 13.9 17.7 23.7
2006 11.3 8.8 14.2 13.0 15.7
2007 12.5 7.5 15.4 11.3 13.6
2008 9.6 6.3 15.8 10.0 11.4
2009 6.1 5.0 15.5 7.1 7.8
2010 5.9 5.7 15.0 6.8 7.9
2011 5.4 5.1 14.1 5.9 6.9
2012 4.8 4.9 13.7 5.3 6.3
2013 5.3 5.1 12.1 5.3 6.3
Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Frequency of the R 2 coefficient with S&P 500 stocks (1995-2013)
Alpha (or idiosyncratic risk) exists!

Summary
SMB, HML and WML
Volatility
Other risk factors
The size effect in the HML risk factor
SHML is the HML factor for small stocks

BHML is the HML factor for big stocks
1 1
HMLt = (Rt (SV) + Rt (BV)) (Rt (SG) + Rt (BG))
2 2
1 1
= (Rt (SV) Rt (SG)) + (Rt (BV) Rt (BG))
2 2
1 1
= SHMLt + BHMLt
2 2
The HML factor may be biased toward a size factor because of two
effects:
the SHML factor contributes more than the BHML factor;
the BHML factor is itself biased by a size effect.

Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Fama-French SHML, BHML and HML factors (1995 2013)

Summary
SMB, HML and WML
Volatility
Other risk factors
Table: Performance of the SHML, BHML and HML factors (1995 2013)
Statistic Factor Asia Pacific Europe Japan North America US
SHML 12.0 7.4 4.2 5.4 5.1
(x ) BHML 1.8 2.6 5.0 0.2 0.6
HML 7.1 5.2 4.8 2.9 2.4
SHML 11.7 10.0 11.0 15.2 13.4
(x ) BHML 15.2 11.0 13.3 11.2 11.9
HML 11.5 9.0 10.3 12.1 11.5
SHML 1.03 0.74 0.38 0.35 0.38
SR (x | r ) BHML 0.12 0.24 0.38 0.02 0.05
HML 0.61 0.57 0.47 0.24 0.20

Summary
SMB, HML and WML
Volatility
Other risk factors
The size bias of the BHML factor
Figure: Size ratio between the big value and the big growth portfolios

Summary
SMB, HML and WML
Volatility
Other risk factors
Stock-based versus fund-based risk factors
Figure: The Morningstar style box

Value Core Growth
Large
Mid
Small
We can build SMB and HML risk factors by using the performance of
mutual funds.
Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Comparison between FF and MF SMB risk factors (US, 1999-2014))

Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Comparison between FF and MF HML risk factors (US, 1999-2014))

Summary
SMB, HML and WML
Volatility
Other risk factors
Table: Correlation between FF and MF risk factors (1999 2013)
Factor Europe Japan US

SMB 79.8 86.0 93.9
HML 55.5 54.3 84.8

Summary
SMB, HML and WML
Volatility
Other risk factors
Figure: Comparison between FF and MF HML risk factors (Europe, 1999-2014))

Summary
SMB, HML and WML
Volatility
Other risk factors
Momentums?
' $

Short-term reversal Trend-following

Long-term reversal
-
k k
1 Day - 1 Month 2 Months - 2 Years 2 Years - 5 Years
Jegadeesh and Titman (1993)

Lehman (1990) De Bondt and Thaler (1985)
& %

Summary
SMB, HML and WML
Volatility
Other risk factors
Carhart four-factor model

Carhart four-factor model
We have:
E [Ri ]Rf = im (E [Rm ] Rf )+ismb E [Rsmb ]+ihml E [Rhml ]+iwml E [Rwml ]
where Rwml is the return difference of winner and loser stocks of the past
twelve months.
Fama and French (2012) considered six portfolios:
Loser Average Winner

Small SL SA SW
Big BL BA BW
They then define the WML factor as follows:

1 1
WMLt = (Rt (SW) + Rt (BW)) (Rt (SL) + Rt (BL))
2 2

Summary
SMB, HML and WML
Volatility
Other risk factors
Performance of the WML factor
Table: Performance of the WML factor

Statistic Period Asia Pacific Europe Japan North America US
#1 3.8 19.9 8.7 22.6 17.6
(x ) #2 11.9 11.5 0.3 1.4 3.7
#3 5.6 2.9 2.0 4.5 9.3
#1 24.7 12.8 22.1 18.7 14.5
(x ) #2 12.7 15.9 14.1 20.0 20.1
#3 15.2 17.3 14.0 15.3 19.9
#1 0.15 1.56 0.40 1.21 1.22
SR (x | r ) #2 0.93 0.72 0.02 0.07 0.19
#3 0.37 0.17 0.14 0.30 0.47
#1 January 1995 March 2000

#2 April 2000 March 2009
#3 April 2009 December 2013

Summary
SMB, HML and WML
Volatility
Other risk factors
Performance of the WML factor

Table: Yearly return of the WML factor (in %)
1995 2.3 24.9 15.4 13.1 14.6
1996 20.2 19.2 6.5 4.5 5.5
1997 25.9 11.4 53.9 11.6 9.5
1998 30.2 17.4 16.6 24.1 22.2
1999 2.6 30.9 66.8 51.3 29.0
2000 15.9 23.5 30.8 9.7 16.9
2001 27.8 22.2 16.0 8.3 10.4
2002 40.7 53.1 6.2 29.5 28.1
2003 11.8 11.5 15.1 10.7 17.8
2004 18.1 7.7 7.3 2.2 0.3
2005 9.7 17.8 21.3 19.7 15.3
2006 26.3 13.1 3.8 4.0 6.5
2007 13.6 20.2 10.0 22.0 22.8
2008 3.4 27.5 15.3 5.9 18.3
2009 39.5 37.6 33.0 42.0 52.7
2010 4.8 30.3 3.3 6.6 5.7
2011 14.3 9.5 3.5 5.1 8.4
2012 19.6 3.6 2.3 0.9 1.1
2013 38.0 20.7 16.1 12.9 6.2
Summary
SMB, HML and WML
Volatility
Other risk factors
Momentum crashes (Daniel and Moskowitz, 2013)
Figure: Distribution of WML monthly returns

Summary
SMB, HML and WML
Volatility
Other risk factors
The size effect in the WML risk factor
Figure: The SWML, BWML and WML factors (1995 2013)

Summary
SMB, HML and WML
Volatility
Other risk factors
The size effect in the WML risk factor
Table: Performance of the SWML, BWML and WML factors (1995 2013)
Statistic Factor Asia Pacific Europe Japan North America US
SWML 12.7 17.7 0.4 7.4 4.9
(x ) BWML 2.9 5.3 2.4 3.0 2.5
WML 8.0 11.5 1.7 5.3 3.8
SWML 16.2 14.1 15.3 19.0 19.4
(x ) BWML 20.9 18.3 20.4 19.8 19.7
WML 17.3 15.5 16.6 18.7 18.8
SWML 0.78 1.25 0.03 0.39 0.25
SR (x | r ) BWML 0.14 0.29 0.12 0.15 0.13
WML 0.46 0.74 0.10 0.28 0.20

Summary
SMB, HML and WML
Volatility
Other risk factors
The size neutrality of the BWML factor
Figure: Size ratio between the big value and the big growth portfolios

Summary
SMB, HML and WML
Volatility
Other risk factors
WML does not exhibit a CTA option profile
Figure: Payoff of CTA and conditional payoff of WML

Summary
SMB, HML and WML
Volatility
Other risk factors
Volatility
Three anomalies
Low volatility anomaly
Idiosyncratic volatility anomaly
Low beta anomaly
They are strongly related.

Summary
SMB, HML and WML
Volatility
Other risk factors
Low volatility anomaly
CAPM
Let x1 and x2 be two diversified portfolios. The expected return is an
increasing function of the volatility of the portfolio:
(x2 ) > (x1 ) (x2 ) > (x1 )
Not always verified (Haugen and Baker, 1991; Clarke et al., 2006; Blitz
and van Vliet, 2007).
Minimum variance portfolio, rank-based portfolios.

Summary
SMB, HML and WML
Volatility
Other risk factors
Idiosyncratic volatility anomaly
Ang et al. (2006) defined IVOL as the volatility of the idiosyncratic risk
i (t) corresponding to the residual of the Fama-French regression:
Ri (t) = i + im Rm (t) + ismb Rsmb (t) + ihml Rhml (t) + i (t)
By sorting stocks by exposure to IVOL, Ang et al. (2006) observed that

the return difference between the first quintile portfolio and the last
quintile portfolio was 1.06% per month in the United States, and that
these results cannot be attributed to size, value, momentum or liquidity
factors (Ang et al., 2009).
Robustness of the results? Bali and Cakini (2008), Fu (2009).

Summary
SMB, HML and WML
Volatility
Other risk factors
Low beta anomaly
Figure: What is the impact of borrowing constraints on the market portfolio?

Summary
SMB, HML and WML
Volatility
Other risk factors
Low beta anomaly
Frazzini and Pedersen (2014)

If the investors face some borrowing contraints, the relationship between
the risk premium and the beta of asset i becomes:
E [Ri ] Rf = i + im (E [Rm ] Rf )
where i = (1 im ) is a decreasing function of i .
This can be linked to the empirical evidence of Black et al. (1972), which
found that the slope of the security market line is lower than the
theoretical slope given by the CAPM.

Summary
SMB, HML and WML
Volatility
Other risk factors
Low beta anomaly

Example
We consider four assets where 1 = 5%, 2 = 6%, 3 = 8%, 4 = 6%,
1 = 15%, 2 = 20%, 3 = 25% and 4 = 20%. The correlation matrix C
is equal to:
1.00
0.10 1.00
C =
0.20 0.60 1.00
0.40 0.50 0.50 1.00
The risk-free rate is set to 2%.
Table: Tangency portfolio x ? without any constraints

Asset xi? i (x ? ) i (x ? )
1 47.50% 0.74 3.00%
2 19.83% 0.98 4.00%
3 27.37% 1.47 6.00%
4 5.30% 0.98 4.00%
Summary
SMB, HML and WML
Volatility
Other risk factors
Low beta anomaly

Let us suppose that the market includes two investors. The first investor
cannot leverage his risky portfolio, whereas the second investor must hold
50% of his wealth in cash. We obtain:
Asset xm,i i i (xm ) i (xm ) i + i (xm )
1 42.21% 0.32% 0.62 2.68% 3.00%
2 15.70% 0.07% 0.91 3.93% 4.00%
3 36.31% 0.41% 1.49 6.41% 6.00%
4 5.78% 0.07% 0.91 3.93% 4.00%
Table: Betting-against-beta (BAB) portfolios

Portfolio #1 #2 #3 #4
x1 1 0 1 5
x2 0 1 1 0
x3 1 0 3 5
x4 0 1 1 0
E [R (x )] 0.79% 0.00% 1.51% 3.94%
(R (x )) 26.45% 21.93% 46.59% 132.24%

Summary
SMB, HML and WML
Volatility
Other risk factors
Low beta anomaly
Table: Performance of the BAB factor (1995-2013)
Asset class (x ) (x ) SR (x | r )
USD Equities 9.04% 14.96% 0.60
JPY Equities 2.65% 13.12% 0.20
DEM Equities 6.38% 17.98% 0.36
FRF Equities 3.03% 26.26% 0.12
GBP Equities 5.31% 14.41% 0.37
International Equities 7.73% 8.20% 0.94
US Treasury Bonds 1.73% 2.95% 0.59
US Corporate Bonds 5.43% 10.81% 0.50
Currencies 1.12% 8.64% 0.13
Commodities 4.78% 17.76% 0.27
All assets 5.36% 4.34% 1.24

Summary
SMB, HML and WML
Volatility
Other risk factors
Links between VOL, IVOL and BAB

CAPM
i2 = (im )2 m
2
+ i2
|{z} | {z } |{z}
VOL BETA IVOL
Figure: Relation between im and IVOLi (Fama-French)

Summary
SMB, HML and WML
Volatility
Other risk factors
Links between VOL, IVOL and BAB
Figure: Difference between the low beta and low volatility anomalies

Summary
SMB, HML and WML
Volatility
Other risk factors
Liquidity
Pstor and Stambaugh (2003) suggested including a liquidity premium in
the Fama-French-Carhart model:
E [Ri ] Rf = im (E [Rm ] Rf ) + ismb E [Rsmb ] + ihml E [Rhml ] +

wml liq
i E [Rwml ] + i E Rliq
where LIQ measures the shock or innovation of the aggregate liquidity.
Alphas of decile portfolios sorted

on predicted liquidity betas
Long Q10 / Short Q1:

9.2% wrt 3F
7.5% wrt 4F

Summary
SMB, HML and WML
Volatility
Other risk factors
Carry
Let Xt be the capital allocated at time t to finance a futures position on
asset St . Koijen et al. (2013) showed that the expected excess return is
the sum of the carry and the expected price change:
Et [St+1 ]
Et [Rt+1 (X )] Rf = Ct +
Xt
where Ct = (St Ft ) /Xt is the carry.
Currencies:
Ct ' it i
Equities:
Ct ' DYt Rf
Bonds
Roll-down strategy
Carry of the slope: Ct ' Rt10Y Rt2Y

Summary
SMB, HML and WML
Volatility
Other risk factors
Carry
Table: Performance of DB currency carry strategies (1995-2013)
Universe (x ) (x ) SR (x | r )
G10 4.31% 10.48% 0.41
Balanced 7.44% 10.87% 0.68
Global 5.02% 11.68% 0.43
Figure: Performance of DB currency carry indices

Summary
SMB, HML and WML
Volatility
Other risk factors
Quality
Piotroski (2000) argues that the success of the value strategy is explained
by the strong performance of quality stocks, and not by the performance
of distressed stocks.
Scoring system:
1 Piotroski (2000): profitability, leverage/liquidity, operating efficiency.
2 Novy-Marx (2013): gross profitability.
3 Asness et al. (2013): profitability, payout ratio, required return,
growth.
Asness et al. (2013) defined the QMJ factor as follows:

1 1
QMJt = (Rt (SQ) + Rt (BQ)) (Rt (SJ) + Rt (BJ))
2 2
with the following six portfolios:
Junk Median Quality
Small SJ SM SQ
Big BJ BM BQ
Summary
SMB, HML and WML
Volatility
Other risk factors
Quality
Table: Statistics for the SQMJ, BQMJ and QMJ factors (1995 2013)
US Global
Statistic
SQMJ BQMJ QMJ SQMJ BQMJ QMJ
(x ) 5.9 2.7 4.4 7.2 3.0 5.2
(x ) 13.5 10.4 10.8 10.0 8.6 8.5
SR (x | r ) 0.44 0.26 0.41 0.73 0.35 0.60
Figure: Performance of the QMJ, SQMJ and BQMJ factors

Summary
Factor indexes
Long/short vs long-only portfolios
Capacity
How to define factor indexes?

Asset universe: academics versus investors
Academics generally use a large asset universe provided by the Center for
Research in Security Prices (CRSP) or Standard and Poors (Compustat
and Xpressfeed).
Table: Average number of stocks to compute FF HML factor
Asia Pacific Europe Japan North America US

Big 326 615 591 888 846
Small 2646 4093 1840 2982 2385
Total 2972 4708 2431 3870 3231
Remark
NBIM had about 1900 and 1300 American and Japanese stocks in its
portfolio at the end of December 2013.

Summary
Factor indexes
Capacity

Asset universe
Figure: Performance of risk factors with the S&P 500 index (1995 2013)

Summary
Factor indexes
Capacity

Weighting scheme
Three weighting methods:

1 Value-weighted (VW) portfolios:

MEi if Ri < Q1
wi
+MEi if Ri > Q2
where Q1 and Q2 are two numbers such that Q1 < R < Q2 .

2 Equally-weighted (EW) portfolio:

1 if Ri < Q1
wi
+1 if Ri > Q2
3 Rank-weighted portfolios:

Ri R
if Ri < Q1
wi
+ Ri R if Ri > Q2

Summary
Factor indexes
Capacity

Weighting scheme
Figure: Comparison of VW and EW risk factors (US, 1995 2013)

Summary
Factor indexes
Capacity

Weighting scheme
Figure: Impact of (Q1 , Q2 ) on HML and WML factors (S&P 500, 1995 2013)

Summary
Factor indexes
Capacity

Factor replication
Factor model
We consider a set of n assets {A1 , . . . , An } and a set of m risk factors
{F1 , . . . , Fm }. We denote by R the (n 1) vector of asset returns at time
t, while is its associated covariance matrix. We also denote by F the
(m 1) vector of factor returns at time t and its associated covariance
matrix. We assume the following linear factor model:
R = + BF +
where is a (n 1) vector, B is a (n m) matrix and is a (n 1)

centered random vector of covariance D.
The beta ij of asset i with respect to factor Fj is (B)i,j .

Summary
Factor indexes
Capacity

Factor replication
Example
We consider n = 6 assets and m = 3 factors. The loadings matrix is:
0.9 0.3 2.5

1.1 0.5 1.5
1.2 0.6 3.4
B=
0.8 0.8 1.2

0.8 0.2 2.1
0.7 0.4 5.2
The three factors are uncorrelated and their volatilities are equal to 20%, 15% and 1%.
We consider a diagonal matrix D with specific volatilities 10%, 13%, 5%, 8%, 18% and
8%.
We have to estimatePthe replication portfolio x in order to define the

replicated factor Fj? = ni=1 xi Ri .

Summary
Factor indexes
Capacity

Factor replication
Table: Minimizing the tracking error volatility

Portfolio #1 #2
Factor 1 2 3 1 2 3
x1 8.4 1.2 0.7 8.5 1.3 1.3
x2 6.3 10.8 1.5 6.4 12.0 2.6 #1 = without
x3 39.9 39.6 2.0 40.5 44.0 3.6 constraints.
x4 23.2 56.3 1.5 23.6 62.5 2.6
x5 3.2 5.7 0.5 3.2 6.4 0.9
x6 19.2 13.3 4.2 19.5 14.8 7.5 #2 = same
1 97.0 1.5 0.1 98.5 1.7 0.1 volatility than
2 2.7 81.0 1.1 2.8 90.0 1.9 the original
3 26.3 246.1 32.4 26.7 273.4 56.9
RC?1 100.0 0.0 0.0 100.0 0.0 0.0
factor.
RC?2 0.0 100.0 0.0 0.0 100.0 0.0
RC?3 0.0 0.0 100.0 0.0 0.0 100.0
Fj? | Fj 3.5 6.5 0.8 3.5 6.7 0.9
?

Fj 19.7 13.5 0.6 20.0 15.0 1.0

Summary
Factor indexes
Capacity

Factor replication
Table: Comparison of the three approaches
Approach Sensitivity Beta Risk contribution

Factor 1 2 3 1 2 3 1 2 3
x1 16.7 16.3 2.2 17.4 4.2 2.7 15.2 13.9 2.1
x2 20.4 27.1 1.3 17.9 40.4 3.7 18.6 42.9 2.9
x3 22.3 32.6 2.9 17.7 16.0 1.0 19.3 2.3 2.5
x4 14.9 43.4 1.0 17.8 55.7 0.5 19.6 68.5 0.1
x5 14.9 10.9 1.8 17.4 29.9 3.6 16.0 15.3 2.6
x6 13.0 21.7 4.5 17.7 1.6 3.9 16.4 5.5 5.4
1 97.1 25.0 1.5 97.1 0.0 0.0 97.3 0.7 0.1
2 8.5 83.6 4.0 0.0 81.0 0.0 0.0 82.7 2.4
3 32.7 252.8 45.6 0.0 0.0 42.7 0.4 0.0 51.7
RC? 1 99.6 11.0 9.8 99.8 0.0 0.0 100.0 0.0 0.0
RC? 2 0.3 91.2 25.3 0.0 100.5 0.0 0.0 100.0 0.0
RC? 3 0.1 2.2 64.8 0.0 0.0 89.5 0.0 0.0 100.0
Fj? | Fj 4.8 8.6 1.0 4.8 9.2 1.1 4.7 8.8 1.0
?

Fj 20.0 15.0 1.0 20.0 15.0 1.0 20.0 15.0 1.0

Summary
Factor indexes
Capacity
From long/short to long-only solutions

Factor replication
Table: Impact of the long-only constraint
Approach Tracking error Sensitivity Beta
Factor 1 2 3 1 2 3 1 2 3
x1 8.5 0.0 0.8 16.7 13.4 1.4 17.4 0.0 0.0
x2 6.4 0.0 0.0 20.4 22.4 0.0 17.9 40.3 0.0
x3 40.5 57.0 2.9 22.3 26.9 2.0 17.7 18.2 1.7
x4 23.6 0.0 0.0 14.9 0.0 0.0 17.8 0.0 0.0
x5 3.2 0.0 0.5 14.9 0.0 1.2 17.4 0.0 2.8
x6 19.5 0.0 0.0 13.0 0.0 0.0 17.7 0.0 0.0
1 98.5 68.3 4.7 97.1 68.9 4.6 97.1 66.2 4.2
2 2.8 34.2 1.9 8.5 31.3 1.4 0.0 31.1 0.4
3 26.7 193.7 13.1 32.7 91.3 12.9 0.0 1.5 11.6
RC? 1 100.0 83.9 89.2 99.6 87.7 90.7 99.8 81.9 78.7
RC? 2 0.0 12.1 7.0 0.3 12.7 2.4 0.0 14.6 1.1
RC? 3 0.0 2.1 4.1 0.1 0.5 6.1 0.0 0.0 8.7
Fj? | Fj 3.5 17.2 1.3 4.8 17.6 1.3 4.8 17.6 1.3
?

Fj 20.0 15.0 1.0 20.0 15.0 1.0 20.0 15.0 1.0
The correlation matrix between replicated portfolios becomes:

1.00
C= 0.93 1.00
0.95 0.99 1.00

Summary
Factor indexes
Capacity
We define the following three risk factors in the case of the

Fama-French-Carhart model:
1
SMB+
t = (Rt (SV) + Rt (SN) + Rt (SG))
3
1
HML+
t = (Rt (SV) + Rt (BV))
2
1
WML+
t = (Rt (SW) + Rt (BW))
2

Summary
Factor indexes
Capacity
Figure: Performance of long/short and long-only risk factors (US, 1995 2013)

Summary
Factor indexes
Capacity
Figure: Performance of long-only risk factors (US, 1995 2013)

Summary
Factor indexes
Capacity
Table: Correlation matrix of risk factors (US, 1995 2013)
Factor MKT SMB HML WML SMB+ HML+ WML+

Volatility 15.9 12.1 11.5 18.8 20.4 17.7 18.4
MKT 100
SMB 25 100
HML 23 36 100
WML 28 8 15 100
SMB+ 87 66 18 22 100
HML+ 87 33 19 34 90 100
WML+ 89 53 29 7 92 81 100

Summary
Factor indexes
Capacity

Long/short portfolio x : 100% of market risk and % of long/short
risk factors.
Long-only portfolio x + : (100 ) % of market risk and % of
long-only risk factors.
Table: Statistics (in %) of long/short and long/only portfolios (US, 1995 2013)
Portfolio #0 #1 #2 #3 #4 #5 #6 #7 #8
SMB 0.0 10.0 20.0 0.0 20.0 30.0 0.0 50.0 100.0
HML 0.0 10.0 20.0 20.0 20.0 30.0 0.0 50.0 100.0
WML 0.0 10.0 0.0 20.0 20.0 30.0 60.0 50.0 100.0
x 9.9 11.2 11.1 12.0 12.5 13.7 13.5 16.0 21.0
+

x 11.0 11.2 11.5 12.1 13.2 12.8 13.5 13.5

x+| x 0.2 0.0 0.5 0.4 0.5 0.8 2.5 7.5

x 15.9 15.6 16.2 14.8 15.5 15.9 16.7 17.3 24.5
+

x 16.2 16.5 16.1 16.9 17.7 17.0 18.1 18.1

x+ | x 1.7 1.0 3.5 3.5 5.2 8.6 8.0 18.1
+

x ,x 99.5 99.8 97.8 98.0 95.8 86.9 89.8 67.8

Summary
Factor indexes
Capacity
Capacity and liquidity
Lesmond et al. (2004): momentum profits are offset by trading costs.

Korajczyk and Sadka (2004): the break-even fund sizes for long-only
momentum strategies are between $2 and $5 billion (relative to
December 1999 market capitalization).
Frazzini et al. (2012) estimate the following break-even sizes (in $
billion) for long/short risk factors:
Factor SMB HML WML STR

US 103 83 52 9
Global 156 190 89 13
The issue for long-term investors is the absolute value of transaction

costs, not the relative value.
/ alpha = 5%, TC = 1%
, alpha = 3%, TC = 1 bp

Summary
A magical world?
Optimal allocation
Robustness
A magical world
Figure: The arithmetic of Sharpe ratio

In the case of long/short risk factors, we have SR (x ) m SR (F) where
SR (F) is the average Sharpe ratio.

Summary
A magical world?
Optimal allocation
Robustness
A magical world
The cash + long/short 5F portfolio
We consider a 5F long/short portfolio with SMB, HML, WML, BAB

and QMJ risk factors.
The targeted volatility is equal to 10%.
Table: Performance of the 5F and MKT portfolios (1995 2013)
Statistic Asia Pacific Europe Japan North America US

5F MKT 5F MKT 5F MKT 5F MKT 5F MKT
(x ) 13.2 9.2 14.3 9.2 6.8 0.6 11.2 10.2 10.0 9.9
(x ) 10.0 21.6 10.0 18.1 10.0 18.6 10.0 15.9 10.0 15.9
SR (x | r ) 1.04 0.29 1.14 0.35 0.40 0.12 0.83 0.47 0.71 0.45
MDD (x ) 21.6 60.2 19.9 58.9 21.4 58.1 17.7 50.9 21.4 50.4

Summary
A magical world?
Optimal allocation
Robustness
A magical world
MKT 5F
The correlation matrix between MKT The correlation matrix between 5F
portfolios for the 5 regions is: portfolios for the 5 regions is:

1.00 1.00
0.78 1.00 0.48 1.00
C = 0.56 0.51 1.00 C = 0.56 0.38 1.00
0.77 0.84 0.50 1.00 0.43 0.74 0.34 1.00

0.76 0.83 0.49 1.00 1.00 0.43 0.74 0.38 0.98 1.00

Summary
A magical world?
Optimal allocation
Robustness
A magical world
Figure: Eigenvalues of the risk factors

Summary
A magical world?
Optimal allocation
Robustness
A magical world
Performance of equally-weighted 5F and MKT global portfolios

(1995 2013)
Statistic 5F MKT
(x ) 13.8 7.7
(x ) 10.0 16.0
SR (x | r ) 1.10 0.31
MDD (x ) 23.3 53.4

Summary
A magical world?
Optimal allocation
Robustness
A magical world
The MKT + long/short 5F portfolio
Table: Performance of the MKT + long/short 5F portfolio (1995 2013)

Statistic Asia Pacific Europe Japan North America US Global
(x ) 20.9 22.2 5.2 19.9 18.5 20.1
(x ) 21.1 16.8 17.8 14.6 14.0 14.2
SR (x | r ) 0.85 1.16 0.13 1.18 1.12 1.22
MDD (x ) 55.3 53.6 55.9 49.6 46.1 45.5
Table: Performance of the MKT portfolio (1995 2013)

(x ) 9.2 9.2 0.6 10.2 9.9 7.7
(x ) 21.6 18.1 18.6 15.9 15.9 16.0
SR (x | r ) 0.29 0.35 0.12 0.47 0.45 0.31
MDD (x ) 60.2 58.9 58.1 50.9 50.4 53.4

Summary
A magical world?
Optimal allocation
Robustness
A magical world
The long/only 5F portfolio
Table: Performance of the long-only 5F portfolio (1995 2013)

(x ) 13.4 15.5 3.1 15.8 14.3 11.3
(x ) 21.9 16.9 18.1 15.2 16.3 15.6
SR (x | r ) 0.48 0.75 0.02 0.86 0.71 0.54
MDD (x ) 60.5 58.1 58.1 52.5 55.3 54.5
Bad times are not always uncorrelated!
Table: Performance of the MKT portfolio (1995 2013)

(x ) 9.2 9.2 0.6 10.2 9.9 7.7
(x ) 21.6 18.1 18.6 15.9 15.9 16.0
SR (x | r ) 0.29 0.35 0.12 0.47 0.45 0.31
MDD (x ) 60.2 58.9 58.1 50.9 50.4 53.4

Summary
A magical world?
Optimal allocation
Robustness
A magical world
The long/only 5F portfolio
Figure: Performance of long-only 5F and MKT global portfolios

Summary
A magical world?
Optimal allocation
Robustness
Optimal allocation
Long/short solution
MVO The optimal solution is:

x ? () 1 (F)
MVO? The risk factors are independent implying that:
(Fj )
xj? 2
(Fj )
ERC If the Sharpe ratio is the same for all risk factors, we obtain the ERC
portfolio:
1
xj?
(Fj )
EW If we assume that expected returns and volatilities are the same for all
the factors, the solution is the EW portfolio:
1
xj? =
m
Summary
A magical world?
Optimal allocation
Robustness
Optimal allocation
Long/short solution
Table: Performance and weights of long/short 5F global portfolios (1995 2013)
EW ERC MVO? MVO

(x ) 13.8 14.0 14.7 15.3
(x ) 10.0 10.0 10.0 10.0
Statistic
SR (x | r ) 1.10 1.11 1.19 1.24
MDD (x ) 23.3 19.8 19.7 21.9
SMB 20.0 25.1 0.0 0.0
HML 20.0 22.6 31.1 46.3
Weight WML 20.0 12.8 13.7 20.6
BAB 20.0 18.2 31.9 26.6
QMJ 20.0 21.4 23.4 6.5

Summary
A magical world?
Optimal allocation
Robustness
Optimal allocation
Long-only solution
Optimal portfolio (maximum Sharpe ratio)

max j Fj+ r j ? , 0 +
max j + j (m r ? ) , 0
xj? 2 or xj? 2
j+ j+
where ? is a weighted average of risk premia and r ? = r + ? .
What is an optimal long-only risk factors?

High alpha;
Low beta if m ' 0 but high beta otherwise;
Low idiosyncratic volatility.

Summary
A magical world?
Optimal allocation
Robustness
Optimal allocation
Long-only solution
Optimal portfolio (tracking error)

Fj+ j m + ?j +
+ (1 j ) r + ?
j
j
xj? 2 or xj? 2
j+ j+
where ?j is the gain or cost on the risk factor Fk+ due to long-only
constraints.
The allocation in the market risk factor is the complementary allocation of

the other risk factors.

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Figure: Comparison of Long/short and long-only solutions
Long/short solution
max (RPj , 0)
xj?
VOL2j
Long-only solution (SR) Long-only solution (TE)
max (RPj j ? , 0) RPj j RPm +?j

xj? xj?
IVOL2j IVOL2j

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Stability
Example
We consider a universe of three risk factors:
j j+ j j+ j
F1 2% 2% 7% 7% 1.10
F2 3% 3% 10% 10% 0.90
F3 3% 3% 12% 12% 1.00
The other parameters are m = 6%, m = 20% and r = 2%.

This initial parameter set is disturbed as follows:
Set #0 #1 #2 #3 #4 #5 #6
2 / 2+ 4% 0%
3 / 3+ 8%
2 0.70
m 10%
m 2%

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Stability
Table: Long/short solution
Set #0 #1 #2 #3 #4 #5 #6
x1? 44.54 40.15 34.68 44.54 44.54 44.54 66.21
x2? 32.73 39.35 25.49 32.73 32.73 32.73 0.00
x3? 22.73 20.50 39.83 22.73 22.73 22.73 33.79
SR (x ? | r ) 0.68 0.78 0.79 0.68 0.68 0.68 0.54

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Stability
Table: Long-only solution (SR)
Set #0 #1 #2 #3 #4 #5 #6
x1? 0.00 0.00 0.00 0.00 33.40 0.00 30.50
x2? 64.39 87.44 47.81 72.74 40.16 74.19 0.00
x3? 35.61 12.56 52.19 27.26 26.44 25.81 69.50
SR (x ? | r ) 0.33 0.37 0.34 0.35 0.58 0.15 0.31
(x ? | b) 2.74 3.52 2.81 2.13 2.64 3.00 2.82
(x ? | b) 7.83 9.04 6.42 9.09 5.63 8.18 8.63
IR (x ? | b) 0.35 0.39 0.44 0.23 0.47 0.37 0.33

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Stability
Table: Long-only solution (TE, = 1)
Set #0 #1 #2 #3 #4 #5 #6
x1? 21.44 0.00 0.00 42.64 21.08 0.00 42.64
x2? 29.83 82.26 14.29 0.00 30.15 58.06 0.00
x3? 48.73 17.74 85.71 57.36 48.78 41.94 57.36
xb? 0.00 0.00 0.00 0.00 0.00 0.00 0.00
SR (x ? | r ) 0.32 0.37 0.33 0.30 0.56 0.15 0.30
(x ? | b) 2.75 3.49 2.94 2.74 2.75 3.00 2.74
(x ? | b) 6.74 8.65 7.01 7.55 6.75 7.77 7.55
IR (x ? | b) 0.41 0.40 0.42 0.36 0.41 0.39 0.36

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Stability
Table: Long-only solution (TE, = 20)
Set #0 #1 #2 #3 #4 #5 #6
x1? 23.65 24.02 23.65 24.63 24.26 20.01 22.64
x2? 13.41 18.23 13.41 8.79 13.11 15.19 0.00
x3? 10.42 10.42 23.44 10.42 10.42 10.42 10.42
xb? 52.52 47.33 39.50 56.16 52.21 54.38 66.94
SR (x ? | r ) 0.26 0.27 0.28 0.25 0.50 0.06 0.24
(x ? | b) 1.23 1.55 1.62 1.06 1.24 1.17 0.86
(x ? | b) 2.48 2.78 2.85 2.30 2.49 2.42 2.07
IR (x ? | b) 0.50 0.56 0.57 0.46 0.50 0.48 0.41

Summary
A magical world?
Optimal allocation
Robustness
Robustness
SAA versus TAA
Constant mix strategy = right answer?
Not obvious if risk premia are time-varying and mean-reverting.
BUT
How to diversify bad times (or skewness premia)?

Summary
A magical world?
Optimal allocation
Robustness
Robustness
Scalability
Scalability of risk factors?
Index-based or fund-based management (execution)?

Conclusion
Factor investing = a powerful tool, but not so easy to manipulate:

The zoo of factors (Cochrane, 2011)
Factor investment products (indexes, strategies & funds) 6= risk
factors
Allocating between risk factors is not straightforward.
Factor investing = a complementary approach and not a substitute to

traditional asset allocation
Investment universe for managing large portfolios

=
Beta (or asset classes) + Risk Factors (or new betas)

Conclusion
Table: Definition of Smart Beta
Risk Factors: Market Risk Factor Other Risk Factors
Traditional Beta Alternative Betas

Beta:
(Old Beta) (New Betas)
CW, EW, SMB, HML, WML,

Smart Beta: MDP, ERC BAB, QMJ
MV?

References
Ang A. (2014).
Asset Management A Systematic Approach to Factor Investing.
Asness C.S., Frazzini A. and Pedersen L.H. (2013).

Quality Minus Junk.
SSRN, www.ssrn.com/abstract=2435323.
Carhart M.M. (1997).
On Persistence in Mutual Fund Performance.
Journal of Finance, 52(1), pp. 57-82.
Cochrane J.H. (2011).

Presidential Address: Discount Rates.
Fama E.F. and French K.R. (2012).

Size, Value, and Momentum in International Stock Returns.
Journal of Financial Economics, 105(3), pp. 457-472.
Frazzini A. and Pedersen L.H. (2013).

Betting Against Beta.
Journal of Financial Economics, 111(1), pp. 1-25.
References
Harvey C.R., Liu Y. and Zhu H. (2014).
. . . and the Cross-Section of Expected Returns.
SSRN, www.ssrn.com/abstract=2249314
Haugen R.A. and Baker N.L. (1991).

The Efficient Market Inefficiency of Capitalization-Weighted Stock Portfolios.
Journal of Portfolio Management, 17(3), pp. 35-40.
Ilmanen A. (2011).
Expected Returns: An Investors Guide to Harvesting Market Rewards.
Jegadeesh N. and Titman S. (1993).

Returns to Buying Winners and Selling Losers: Implications for Stock Market
Efficiency.
Pastor L. and Stambaugh R.F. (2001).

Liquidity Risk and Expected Stock Returns.
Journal of Political Economy, 111(3), pp. 642-685.
Tables
For Year 2014, all computations are done on the full year except:
() : January-November 2014;
() : January-October 2014.
The source of data are the following:

Kenneth French library for MKT, SMB, HML and WML;
AQR library for BAB and QMJ.
Tables
Yearly return of the MKT factor (in %)

1995 14.9 19.3 2.5 35.7 36.8
1996 22.9 21.9 16.1 22.3 21.1
1997 20.6 19.9 28.7 30.8 31.2
1998 6.7 25.5 7.5 22.9 24.3
1999 46.6 19.7 81.7 23.3 25.2
2000 15.6 9.9 32.9 7.8 11.6
2001 8.1 20.0 28.9 10.7 11.4
2002 7.0 14.0 7.8 21.3 21.1
2003 50.5 42.7 41.0 32.5 31.8
2004 28.6 23.6 17.3 13.1 11.9
2005 13.4 11.9 27.2 7.9 6.1
2006 33.8 37.0 1.0 15.6 15.4
2007 36.5 14.1 4.9 7.8 5.7
2008 51.1 45.7 26.0 37.9 36.7
2009 77.4 35.5 5.2 31.9 28.3
2010 22.4 6.1 16.2 18.3 17.5
2011 15.2 13.0 10.3 0.7 0.5
2012 24.6 21.1 6.5 15.6 16.4
2013 6.2 28.5 26.7 32.3 35.2
2014 1.6 6.5 2.6 10.7 11.7
Tables
Yearly return of the SMB factor (in %)

1995 10.3 8.3 3.5 3.1 5.7
1996 4.0 1.9 8.6 3.1 2.0
1997 9.3 12.3 33.1 8.8 4.8
1998 15.8 13.6 8.9 19.6 19.3
1999 12.9 11.7 8.9 9.8 13.4
2000 20.1 7.0 1.1 3.1 4.8
2001 3.6 0.7 5.1 16.3 20.4
2002 1.4 6.5 2.1 0.6 3.9
2003 13.5 8.8 14.3 17.6 22.2
2004 6.2 7.5 17.0 5.7 5.0
2005 9.6 5.0 10.7 0.0 1.8
2006 7.1 6.1 20.4 0.6 0.5
2007 0.3 8.0 7.3 5.8 7.8
2008 22.4 10.2 6.3 0.7 7.0
2009 20.4 8.6 0.3 9.6 7.9
2010 9.4 9.7 4.5 15.7 12.9
2011 10.6 8.7 9.3 6.1 5.0
2012 9.1 1.0 1.3 0.6 0.5
2013 1.0 6.2 3.1 2.0 6.0
2014 4.1 2.0 6.8 7.4 7.0
Tables
Yearly return of the HML factor (in %)

1995 1.0 5.0 3.5 2.0 0.8
1996 7.1 1.6 9.0 5.2 1.4
1997 2.4 12.2 12.8 11.4 9.6
1998 11.3 0.6 1.7 13.6 10.2
1999 11.5 17.0 32.5 25.3 26.7
2000 23.7 33.0 60.1 48.9 37.3
2001 18.0 33.0 20.2 11.7 14.8
2002 18.3 26.9 14.4 18.2 12.6
2003 13.7 15.6 9.2 4.6 3.2
2004 8.3 9.2 8.6 9.0 8.7
2005 1.5 8.0 0.3 7.0 8.6
2006 2.1 7.9 14.5 11.6 12.7
2007 4.5 0.6 5.9 12.4 11.6
2008 9.0 3.1 21.3 0.2 2.0
2009 5.1 1.7 3.8 1.7 1.8
2010 1.1 5.3 0.3 1.1 2.1
2011 1.9 14.1 5.5 4.5 6.8
2012 14.9 1.4 1.6 5.6 6.8
2013 5.0 7.9 2.3 0.7 0.4
2014 9.2 6.1 0.3 5.6 3.5
Tables
Yearly return of the SHML factor (in %)

1995 2.9 3.1 0.7 3.6 2.4
1996 3.3 2.4 3.9 8.6 10.6
1997 11.0 14.3 1.6 19.4 22.7
1998 8.1 4.2 3.5 7.2 3.1
1999 16.5 22.8 39.0 28.6 29.8
2000 30.4 33.4 49.3 57.5 40.0
2001 29.6 50.1 21.3 14.1 15.6
2002 34.6 45.2 19.4 31.3 29.4
2003 23.2 13.1 6.5 0.9 6.1
2004 12.1 10.3 2.6 6.5 5.8
2005 10.4 11.0 1.7 5.2 9.7
2006 0.2 4.4 19.5 11.8 12.2
2007 22.7 6.6 11.7 9.6 15.5
2008 19.4 8.3 20.9 16.9 11.4
2009 6.8 2.9 3.7 0.1 1.0
2010 7.8 4.4 4.7 0.7 0.1
2011 1.9 10.3 9.6 0.5 3.4
2012 18.8 1.4 1.6 4.5 5.5
2013 15.8 7.3 1.3 0.9 2.5
2014 4.2 1.4 1.9 5.9 3.9
Tables
Yearly return of the BHML factor (in %)

1995 1.2 6.9 6.3 0.5 0.8
1996 18.1 0.8 14.2 1.7 7.2
1997 14.7 10.1 23.4 3.6 2.7
1998 13.5 3.4 6.8 19.9 17.0
1999 6.5 11.0 27.0 22.3 23.9
2000 14.7 31.7 70.9 38.9 34.0
2001 6.9 16.7 18.5 8.6 13.6
2002 3.6 9.7 9.2 5.5 3.1
2003 4.6 18.0 26.2 8.3 0.3
2004 4.2 8.0 14.3 11.4 11.8
2005 7.0 5.0 2.6 8.6 7.5
2006 3.8 11.4 9.7 11.3 13.0
2007 11.7 7.5 0.1 15.1 7.5
2008 1.2 13.6 21.4 14.6 7.0
2009 3.8 5.8 4.2 3.5 5.0
2010 5.7 6.5 5.3 1.5 4.4
2011 5.8 17.9 1.5 9.3 10.2
2012 10.9 4.0 1.8 6.6 8.0
2013 5.1 8.4 5.9 2.3 3.2
2014 14.4 10.6 2.6 5.4 3.2
Tables
Yearly return of the WML factor (in %)

1995 2.3 24.9 15.4 13.1 14.6
1996 20.2 19.2 6.5 4.5 5.5
1997 25.9 11.4 53.9 11.6 9.5
1998 30.2 17.4 16.6 24.1 22.2
1999 2.6 30.9 66.8 51.3 29.0
2000 15.9 23.5 30.8 9.7 16.9
2001 27.8 22.2 16.0 8.3 10.4
2002 40.7 53.1 6.2 29.5 28.1
2003 11.8 11.5 15.1 10.7 17.8
2004 18.1 7.7 7.3 2.2 0.3
2005 9.7 17.8 21.3 19.7 15.3
2006 26.3 13.1 3.8 4.0 6.5
2007 13.6 20.2 10.0 22.0 22.8
2008 3.4 27.5 15.3 5.9 18.3
2009 39.5 37.6 33.0 42.0 52.7
2010 4.8 30.3 3.3 6.6 5.7
2011 14.3 9.5 3.5 5.1 8.4
2012 19.6 3.6 2.3 0.9 1.1
2013 38.0 20.7 16.1 12.9 6.2
2014 11.2 4.9 3.6 1.2 1.4
Tables
Yearly return of the SWML factor (in %)

1995 14.7 30.0 19.5 23.8 25.8
1996 19.1 31.2 14.6 10.3 6.3
1997 25.7 12.2 29.0 16.5 15.1
1998 19.7 28.2 17.1 24.6 25.0
1999 4.6 52.5 45.2 56.2 32.0
2000 15.2 16.6 21.8 10.3 43.6
2001 41.1 26.7 13.3 14.1 17.2
2002 43.8 64.6 1.5 34.8 36.9
2003 14.7 11.3 15.3 10.8 16.7
2004 24.3 12.1 12.0 3.3 0.3
2005 11.6 27.2 19.8 19.0 15.6
2006 35.6 15.9 3.8 1.8 3.9
2007 24.1 21.8 14.1 21.9 18.0
2008 12.4 32.0 14.3 2.9 7.9
2009 42.2 34.7 34.5 49.1 60.8
2010 11.0 36.4 1.5 5.5 1.9
2011 17.8 17.8 0.9 11.9 16.5
2012 32.3 9.8 1.4 4.0 3.4
2013 41.3 25.6 18.9 15.9 5.8
2014 25.0 15.1 2.5 3.3 1.2
Tables
Yearly return of the BWML factor (in %)

1995 9.1 19.7 11.3 3.2 4.2
1996 20.9 8.2 2.2 1.2 4.5
1997 25.4 10.3 81.7 6.6 3.9
1998 41.2 6.8 16.8 23.4 18.9
1999 9.3 11.0 88.5 45.7 25.3
2000 17.3 30.3 39.4 27.2 5.8
2001 15.1 17.0 17.8 2.5 3.4
2002 37.0 42.0 13.6 23.9 19.2
2003 8.8 11.9 15.3 10.7 18.9
2004 12.0 3.5 2.7 1.0 0.3
2005 7.7 9.0 22.5 20.1 14.8
2006 17.4 10.3 4.1 6.3 9.1
2007 3.5 18.6 5.7 21.9 27.7
2008 5.3 22.8 15.7 8.6 29.3
2009 36.8 40.5 31.7 34.1 43.2
2010 1.4 24.3 7.9 7.6 9.5
2011 10.6 1.5 8.0 1.3 0.7
2012 7.8 2.5 2.9 2.1 5.6
2013 34.0 15.9 13.3 9.8 6.4
2014 1.5 4.5 4.8 0.7 1.6
Tables
Yearly return of the BAB factor (in %)
Year Asia Pacific() Europe() Japan() North America() US()

1995 10.6 9.6 10.8 22.6 23.7
1996 0.1 13.4 4.8 31.1 31.8
1997 9.8 5.1 15.6 45.8 47.1
1998 11.0 9.9 8.5 13.0 13.2
1999 29.9 9.8 30.7 34.2 35.3
2000 5.4 23.4 13.4 14.0 14.3
2001 6.8 17.9 4.5 12.6 12.3
2002 12.7 52.6 7.4 37.0 35.4
2003 6.7 21.4 1.6 16.2 10.4
2004 22.7 46.3 21.6 31.8 30.3
2005 14.6 4.1 13.5 14.8 12.9
2006 7.4 28.2 3.9 12.6 11.0
2007 30.9 14.8 2.9 4.2 6.8
2008 0.1 20.7 23.2 33.9 35.0
2009 21.9 6.3 10.6 16.2 9.9
2010 22.1 4.4 3.1 8.4 6.4
2011 11.1 17.8 22.9 5.6 4.1
2012 7.8 3.6 0.6 16.7 16.0
2013 12.0 16.8 7.5 20.6 20.3
2014 19.8 8.3 15.3 13.0 12.2
Tables
Yearly return of the QMJ factor (in %)
Year Asia Pacific() Europe() Japan() North America() US()

1995 2.5 7.6 2.9 3.6 3.3
1996 6.0 3.4 8.4 8.7 9.0
1997 22.7 5.3 22.3 8.5 8.0
1998 1.1 6.6 1.1 13.4 13.5
1999 2.4 8.5 4.5 7.1 7.8
2000 13.1 6.7 6.9 24.4 24.0
2001 15.7 14.9 16.9 17.0 16.1
2002 11.3 17.0 7.4 23.4 22.6
2003 19.8 12.5 26.2 17.9 18.2
2004 5.3 4.3 8.1 0.7 0.0
2005 9.5 3.0 16.9 1.1 0.4
2006 17.1 2.4 28.0 5.1 4.8
2007 8.0 11.6 13.5 8.0 6.9
2008 25.8 31.4 15.6 38.7 38.1
2009 5.9 5.7 2.7 14.7 14.4
2010 2.5 2.6 1.2 7.7 7.6
2011 16.0 24.7 14.6 22.4 21.8
2012 3.2 0.5 9.0 3.7 5.8
2013 2.6 2.7 10.4 0.1 2.0
2014 7.4 9.2 11.2 4.5 3.1
Tables
Yearly return of the SQMJ and BQMJ factors (in %) US
Year SQMJ() BQMJ() QMJ()

1995 0.5 6.0 3.3
1996 10.0 7.9 9.0
1997 16.0 0.3 8.0
1998 11.2 15.6 13.5
1999 8.6 7.4 7.8
2000 40.4 8.0 24.0
2001 14.9 16.3 16.1
2002 36.6 9.5 22.7
2003 22.4 13.9 18.2
2004 6.1 5.9 0.0
2005 3.7 4.4 0.4
2006 3.3 6.4 4.8
2007 5.7 8.1 6.9
2008 37.4 38.5 38.1
2009 19.7 9.1 14.4
2010 6.6 8.6 7.6
2011 22.0 21.4 21.8
2012 5.7 6.1 5.8
2013 0.0 3.9 1.9
2014 2.0 4.1 3.1
Tables
Yearly return of the SQMJ and BQMJ factors (in %) Global
Year SQMJ() BQMJ() QMJ()

1995 0.4 5.5 2.9
1996 7.1 5.9 6.6
1997 11.0 3.3 7.1
1998 9.1 10.4 9.8
1999 6.7 5.1 5.8
2000 28.7 8.3 18.5
2001 20.0 12.5 16.4
2002 33.5 8.4 20.4
2003 19.1 13.9 16.5
2004 6.3 4.3 0.9
2005 1.4 5.4 2.0
2006 1.8 2.4 0.3
2007 9.4 8.9 9.2
2008 33.0 34.8 34.0
2009 11.5 8.3 9.8
2010 0.2 4.8 2.5
2011 22.8 20.7 21.8
2012 2.1 4.5 1.2
2013 5.0 2.5 1.2
2014 7.1 6.0 6.5

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Summary

Empirical Evidence of Risk Factors

Factor Investing and Equity Portfolio Construction1

Amsterdam, January 2015

Lyxor Research Paper

3 From Risk Factors to Factor

2 Empirical Evidence of Risk 4 Asset Allocation with Risk

Thierry Roncalli Factor Investing and Equity Portfolio Construction 3 / 114

Risk factors versus factor investing

Risk factors are one of the pillars of performance measurement (Carhart,

Thierry Roncalli Factor Investing and Equity Portfolio Construction 4 / 114

Risk factors versus factor investing

Factor investing (marketing message)

Factor investing consists in:

Thierry Roncalli Factor Investing and Equity Portfolio Construction 5 / 114

What is the rationale for factor investing?

At the security level, there is a lot of idiosyncratic risk or alpha:

Thierry Roncalli Factor Investing and Equity Portfolio Construction 6 / 114

What is the rationale for factor investing?

Idiosyncratic risk decreases with the size of the investment portfolios:

Thierry Roncalli Factor Investing and Equity Portfolio Construction 7 / 114

What is the rationale for factor investing?

2009: Professors Report on the Norwegian GPFG (Ang, Goetzmann

What lessons can we draw from this?

Alpha is not scalable, but risk factors are scalable.

Is that really true?

Thierry Roncalli Factor Investing and Equity Portfolio Construction 8 / 114

The cross-section of expected returns

Cross-section of expected returns

Two statistical tools are used:

Thierry Roncalli Factor Investing and Equity Portfolio Construction 9 / 114

Risk premium versus risk premia

Thierry Roncalli Factor Investing and Equity Portfolio Construction 10 / 114

Risk factors and anomalies

Thierry Roncalli Factor Investing and Equity Portfolio Construction 11 / 114

Figure: Harvey et al. (2014)

Now we have a zoo of new factors (Cochrane, 2011).

Factors, factors everywhere

Standard predictive regressions fail to reject the hypothesis that

Thierry Roncalli Factor Investing and Equity Portfolio Construction 13 / 114

The alpha puzzle (Cochrane, 2011)

Fama and French (1992)

E [Ri ] Rf = im (E [Rm ] Rf ) + ismb E [Rsmb ] + ihml E [Rhml ]

This is not the end of the story...

Thierry Roncalli Factor Investing and Equity Portfolio Construction 14 / 114

The alpha puzzle (Cochrane, 2011)

How can alpha always come back?

Facts and fantasies

Thierry Roncalli Factor Investing and Equity Portfolio Construction 16 / 114

Facts and fantasies

Risk premia are time-varying and low-frequency mean-reverting. The

Facts and fantasies

Factor investing is not a new investment style. It has been largely

Thierry Roncalli Factor Investing and Equity Portfolio Construction 18 / 114

Facts and fantasies

Thierry Roncalli Factor Investing and Equity Portfolio Construction 19 / 114

Facts and fantasies

HML is much more rewarded than WML.

Facts and fantasies