Diversify and Purify Factor Premiums in Equity Markets

24 Pages Posted: 9 Jan 2017  

Raul Leote de Carvalho

BNP Paribas Investment Partners

Lu Xiao

BNP Paribas Investment Partners

François Soupé

THEAM, BNP Paribas Investment Partners

Patrick Dugnolle

BNP Paribas - BNP Paribas Investment Partners

Date Written: January 2, 2017

Abstract

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.

Keywords: Factor Investing, Value, Quality, Momentum, Low Risk, Smart Beta, Equities

JEL Classification: G02, G11, G12, G17

Suggested Citation

Carvalho, Raul Leote de and Xiao, Lu and Soupé, François and Dugnolle, Patrick, Diversify and Purify Factor Premiums in Equity Markets (January 2, 2017). Available at SSRN: https://ssrn.com/abstract=2894171 or http://dx.doi.org/10.2139/ssrn.2894171

Raul Leote de Carvalho (Contact Author)

BNP Paribas Investment Partners ( email )

Paris
France
0033158972183 (Phone)

Lu Xiao

BNP Paribas Investment Partners ( email )

14 rue bergère
Paris, 75009
France

François Soupé

THEAM, BNP Paribas Investment Partners ( email )

14 rue Bergere
Paris, 75009
France

Patrick Dugnolle

BNP Paribas - BNP Paribas Investment Partners ( email )

14 Rue Bergère
Paris, 75009
France

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