For professional investors only

A brief history
of factor
investing
 Understand. Act.
AllianzGI Systematic Equity Paper, December 2016

Dr Klaus Teloeken Dr Benedikt Henne Philip Dawes

Co-CIO Systematic Co-CIO Systematic Head of UK
Equity Team Equity Team Institutional Sales UK

Equity market investors have traditionally been told

that active management is a zero sum game and that
it does not add value; cue the stampede toward
passive investments and ETFs that are low cost index
trackers. What type of investments these provide
investors is: a return of the market, less costs and
charges, whilst maintaining the volatility of the index
being followed. However, in an environment where
lower nominal global Gross Domestic Product growth
and thus lower equity market returns (than have been
seen in previous years) are expected, the incremental
value that can be added through active management
becomes even more appealing.

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Understand. Act.
AllianzGI Systematic Equity Paper, December 2016
A stylish approach to consistency; a brief
history of factor investing
The question for investors is, how do I select an active manager that will
add value on a consistent basis?
One way to achieve this is to appoint a bottom-up
stock picker who, pursuing a consistent philosophy
and process, will outperform the market by picking
the winners and avoiding the losers. Such an active
approach will introduce idiosyncratic and systemic
risk (versus a broad market index) into a portfolio of
equities and will likely utilise factor exposures as a
means of monitoring risk and maintaining style
consistency through time. Increasingly, such
approaches are typified by unconstrained, concen-
trated portfolios that focus on high tracking errors
(relative to benchmark) and high levels of active share.
An alternative approach to delivering sustainable
outperformance is to construct a portfolio that
systematically harvests the excess returns associated
with investment styles. Over the last two decades,
considerable academic evidence has developed that
suggests when examining the returns of active
managers, outperformance can be attributed in a
significant part to investment style risk premia. Unlike
traditional active approaches, such multi-factor
strategies diversify equity portfolios across investment
styles, typically have lower tracking errors and use
security selection as a means of risk control that
ensure each investment style is replicated. This can be
achieved without compromising active share.
Both approaches to active management are valid and
can deliver sustainable long-term outperformance for
investors but traditional active approaches can be
volatile (in the short-term) as they are rarely
diversified across investment styles that are cyclical in
nature.
The history of style factors as a means of
explaining stock returns
What is the academic evidence that underpins the
belief that investment styles can deliver excess
returns? In the beginning, the Capital Asset Pricing
Model (CAPM), first introduced by Sharpe (1964)1,
explained the pricing of securities using a single factor
(beta) which described how much a stock moved
compared to the market. Stocks with a higher beta
thus had higher risk associated with them and could
command higher expected returns. As a means of
explaining stock returns this approach has been
subsequently revised and enhanced to incorporate
other factors (styles) that also help to explain stock
returns.
Value and size
Style investing is not a new phenomenon. Graham
and Dodd first wrote about the Value premium in
19342, following the Wall Street Crash, which
encouraged investors to focus on the value of the
operating business that lay behind a given stock and
highlighted the markets tendency to irrationally
under-value out of favour securities. This work was
formalised by Basu3 in 1977 who identified low price
to earnings ratios as a predictor of subsequent returns.
Fama and French (1992, 1993)4 developed this further
by developing a three-factor model that described the
cross-section of US stock returns in terms of two main
styles, value and size.
Whilst the existence of the value premium is not
disputed there are divergent opinions as to its cause.
From the perspective of the efficient markets view (see
Zhang, 2005 and Cochrane, 1991, 1996)5, the higher
return of value stocks represents compensation to the
investor for the higher risk associated with these
companies, tending to be more cyclical, more highly
leveraged and less profitable than growth stocks. From
a behavioural perspective, the value premia may stem
from cognitive biases that cause investors to become
overly pessimistic on certain stocks as investors tend to
over-react to negative and short-term trends.
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 Understand. Act.
AllianzGI Systematic Equity Paper, December 2016
Momentum
Since the identification of value and size as drivers of
stock returns, additional investment styles have
subsequently been identified and verified. The
momentum factor captures the effect that stocks that
have performed well in the past tend to continue to
perform well and stocks with low returns in the past
tend to continue to exhibit low returns. Typically price
trends are mean reverting over shorter periods of up
to 3-months, trend following over medium time
periods of 6-18-months and mean reverting over
longer periods of more than 48-months. Hence the
most important momentum effect is the persistence
of medium term momentum. The seminal study of
Jegadeesh and Titman (1993)6 was the first to
document this phenomena in the US with Carhart
(1997)7 adding momentum to the Fama and French
two factor model with similar results found for other
regions e.g. Rouwenhorst (1998)8.
As with the value premium the theoretical
explanation for this observation is still a matter for
extensive discussion in the academic literature.
Behavioural finance experts contend that investors
either over-react to news in the very short-term or the
very long-term, causing momentum to mean-revert
to correct the over-reaction (Barberis, Shleifer and
Vishny, 19989). Similarly, investors may under-react to
news over the medium-term, resulting in the
persistence of medium-term momentum (Hong and
Stein, 200010). Other studies argue that the
momentum effect is based on a risk premium where
momentum stocks have a higher downside risk which
makes them less attractive and thus investors should
expect to receive additional compensation (see Ang
and Xing, 200611 or Lettau, Maggiori and Weber,
201412).
Quality
It is well documented that stocks with positive earnings
forecast revisions by stock
analysts exhibit positive
returns for a longer period
of time after the revisions
and vice versa for negative
revisions. This effect was first documented
by Givoly and Lakonishok (1979)13 but can
be found in more recent studies such as
Womack (1996)14 or Da and Warachka
(2009)15. Again there are several behavioural
4
explanations for this effect but a prominent one refers
to the anchoring effect which suggests that cognitive
bias causes analysts to adjust their earnings
expectations slowly over time (difference anchors are
discussed) which causes the price to reflect this new
information over time (Cen, Gilles and Wei, 201316).
The quality factor is closely related to the profitability
of a company. Fama and French17 re-enter the fray in
2015 to show that the persistent profitability of a
company is positively related with stock return and
that this relationship is largely unexplained by their
previous three-factor model. The performance
success of quality stocks was documented by Sloan
(1996)18 for stocks with high earnings quality.
Additionally Novy-Marx (2013)19 shows that more
profitable firms have significantly higher returns than
unprofitable firms despite having significantly higher
valuation ratios.
Volatility
As quality stocks typically also exhibit lower volatility,
the longer term success of quality stocks overlaps with
the long-term success of lower volatility names first
suggested by Black (1972)20. The low volatility effect
captures the counter-intuitive finding that stocks with
lower than average volatility, beta and/or idiosyncratic
risk earn higher returns on average. At first glance this
violates one of the most basic ideas of the CAPM
model, namely that higher volatility is associated with
higher returns. Haugen and Baker (1991)21
documented this effect for low volatility stocks in the
US with later studies confirming this thesis for several
different volatility measures (Chan, Karceski and
Lakonishok, 199922; Clarke, De Silva and Thorley,
200623; Nielsen and Subramanian, 200824).
Behavioural explanations for this volatility effect focus
on biases leading to excess demand for higher risk
stocks. Institutional investors are incentivised to
outperform a benchmark which makes low (and high)
beta stocks unattractive (see Baker and Haugen,
201225). Risk premia explanations centre around the
variability of beta where turbulent markets betas tend
to converge to one, hence low beta stocks are more
risky than suggested by typical beta estimates. This is
unattractive for any risk averse investor and hence
should be compensated (Boyer, Mitton and Vorkink,
200926; Conrad, Dittmar and Ghysels, 201327).
Understand. Act.
AllianzGI Systematic Equity Paper, December 2016

Evolution of harvesting risk premia

Investment style risk premia are an important driver of active equity returns

Alpha / Alpha /
Idiosyncratic Risk Idiosyncratic Risk

Value
factor
Alpha /
Idiosyncratic Risk Small Cap
factor
Active
Returns
Value Momentum
factor factor

Small Cap Low Volatility

factor factor

Excess Excess Excess

Market Market Market
Beta Beta Beta

1980s 1990s 2000s

Performance based on Managers Skills Performance coming from Risk Premia

Source: MSCI, Allianz Global Investors.

Growth over the medium to long-term has contributed to the

The growth premium has also recently been
highlighted by academics where stable growth stocks
with a track record of delivered growth have shown to
have significantly higher risk adjusted returns. Novy-
Marx (201328) finds that profitability is associated with
long run growth in profits, earnings, free cash-flows
and dividends. As stable growth stocks are typically
also quality stocks (as well as lower volatility names),
the stable growth premium is strongly over-lapping
with the quality and low volatility risk premia.
What does this all mean for investors?
The insight that different factor exposures
(investment styles) may generate excess performance
growth of style ETFs and so called Smart Beta indices,
constructed to capture this expected excess return.
This appears to be a lower risk and lower cost solution
to investors need for return.
While the academic evidence demonstrates that
investment style risk premia exist, and that it makes
sense for an investor to tilt portfolios toward factor
risk premia, the research also shows that individual
investment styles fail to deliver excess returns
consistently as economic or market conditions
change.
We consider multi-factor investing a better approach.
This seeks to provide less volatile excess returns by
harvesting the risk premia associated with the

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 Understand. Act.
AllianzGI Systematic Equity Paper, December 2016
numerous investment styles discussed within this
paper. By constructing a diversified portfolio that
seeks exposure to all known investment styles one
can smooth portfolio returns and provide consistent
excess returns. This is made possible by the varying
correlations of individual investment styles.
Those focused on the costs associated with active
management will argue that investors could replicate
such a multi-factor approach by holding multiple,
complimentary Smart Beta indices. However, just
blending passive indices together can create
unintended risk and concentration within segments of
the market that can lead to unintended outcomes.
Active multi-factor investing can analyse these in a
multivariate framework and optimise portfolios to
create more efficient portfolios.
This paper will be followed in Q4
2015 by an appraisal of efficient
portfolio construction when
harvesting equity risk premia.
1 Sharpe, Capital asset prices: A theory of market
equilibrium under conditions of risk, (1964).
Journal of Finance 19.3.
2 Graham, Benjamin, Dodd and Cottle, Security
Analysis, (1934). New York: McGraw-Hill.
3 Basu, Investment performance of common
stocks in relation to their Price-Earnings Ratios: A
test of the efficient market hypothesis, (1977).
Journal of Finance 12.3.
4 Fama and French, The cross-section of expected
stock returns, (1992). Journal of Finance 47.2.
Common risk factors in the returns on stocks
and bonds, (1993). Journal of Financial
Economics 33.1.
5 Zhang, The value premium, (2005). Journal of
Finance 60.1. Cochrane, Production based asset
pricing and the link between stock returns and
economic fluctuations, (1991). Journal of
6
Finance XLVI. A cross-sectional test of an
investment based asset pricing model, (1996).
Journal of Political Economy 104.
6 Jegadeesh and Titman, Returns to buying
winners and selling losers: Implications for stock
market efficiency, (1993). Journal of Finance 48.1.
7 Carhart, On persistence in mutual fund
performance, (1997). Journal of Finance 52.1.
8 Rouwenhorst, International momentum
strategies, (1998). Journal of Finance 53.1.
9 Barberis, Shleifer and Vishny, A model of investor
sentiment. (1998). Journal of Financial
Economics 49.3.
10 Hong, Lim and Stein, Bad news travels slowly:
Size, analyst coverage and the profitability of
momentum strategies, (2000). Journal of
Finance 55.1.
11 Ang, Chen and Xing, Downside risk, (2006).
Review of Financial Studies 19.4.
12 Lettau, Maggiori and Weber, Conditional risk
premia in currency markets and other asset
classes, (2014). Journal of Financial Economics
114.2.
13 Givoly and Lakonishok, The information content
of financial analysts forecasts of earnings: Some
evidence on semi-strong inefficiency, (1979).
Journal of Accounting and Economics 1.3.
14 Womack, Do brokerage analysts
recommendations have investment value?
(1996). Journal of Finance 51.1.
15 Da and Warachka, Cashflow risk, systematic
earnings revisions and the cross section of stock
returns, (2009). Journal of Financial Economics.
94.3
16 Cen, Gilles and Wei, The role of anchoring bias in
the equity market: Evidence from analysts
earnings forecasts and stock returns, (2013).
Journal of Financial and Quantitative Analysis
48.01.
17 Fama and French, A five-factor asset pricing
model, (2015). Journal of Financial Economics
116.1.
18 Sloan, Do stock prices fully reflect information in
accruals and cash-flows about future earnings?
(1996). Accounting Review 71.3.
19 Novy-Marx, The other side of value: The gross
profitability premium, (2013). Journal of
Financial Economics 108.1.
20 Black, Capital market equilibrium with restricted
borrowing, (1972). Journal of Business 45.3.
Understand. Act.
AllianzGI Systematic Equity Paper, December 2016

21 Haugen and Baker, The efficient market misconduct. The conditions of any underlying offer or
inefficiency of capitalisation weighted stock contract that may have been, or will be, made or
portfolios, (1991). Journal of Portfolio
concluded, shall prevail.
Management 17.3.
22 Chan, Karceski and Lakonishok, On portfolio This is a marketing communication issued by Allianz
optimisation: Forecasting co-variances and Global Investors GmbH, www.allianzgi.com, an
choosing the risk model, (1999). Review of
investment company with limited liability,
Financial Studies.
incorporated in Germany, with its registered office at
23 Clarke, De Silva and Thorley, Minimum-variance Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M,
portfolios in the US equity market, (2006). registered with the local court Frankfurt/M under HRB
Journal of Portfolio Management 33.1.
9340, authorised by Bundesanstalt fr
24 Nielsen and Subramanian, Far from the Finanzdienstleistungsaufsicht (www.bafin.de).
madding crowd volatility efficient indexes,
(2008). MSCI Barra Research insights.
25 Baker and Haugen, Low risk stocks outperform
within all observable markets of the world,
(2012). SSRN 2055431.
26 Boyer, Mitton and Vorkink, Expected For further information on how
idiosyncratic skewness, (2009). Review of AllianzGI can help you, please
Financial Studies hhp041.
contact:
27 Conrad, Dittmar and Ghysels, Ex ante skewness
and expected stock returns, (2013). Journal of
Finance 68.1. Margaret Frost
28 Novy-Marx, The other side of value: The gross Head of Institutional UK
profitability premium, (2013). Journal of Tel: 020 3246 7385
Financial Economics 108.1. Email: margaret.frost@allianzgi.com

Disclaimer Philip Dawes

Head of Institutional Sales UK
Investing involves risk. The value of an investment and Tel: 020 3246 7443
the income from it could fall as well as rise and Email: philip.dawes@allianzgi.com
investors might not get back the full amount invested.

Past performance is not a reliable indicator of future

Johnnie Barnett
results. If the currency in which the past performance Institutional Business Development
is displayed differs from the currency of the country in Tel: 020 3246 7555
which the investor resides, then the investor should be Email: johnnie.barnett@allianzgi.com
aware that due to the exchange rate fluctuations the
performance shown may be higher or lower if Corinne Crawford
converted into the investors local currency. Head of Consultant Relations UK
Tel: 020 3246 7474
The views and opinions expressed herein, which are Email: corinne.crawford@allianzgi.com
subject to change without notice, are those of the
issuer companies at the time of publication. The data
used is derived from various sources, and assumed to
Victoria Blackman
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