While a growing body of research shows that exposure to factors, such as Value, Momentum, Low Size and Low Volatility, has produced positive excess returns, factor investing for large-scale portfolios has not been well studied.
MSCI was engaged by the Norwegian Ministry of Finance to analyze simple, rules-based factor indexes, with an emphasis on risk, performance and investability. Our analyses focused on high-capacity MSCI Factor Indexes, which are designed to represent the long-term performance of specific risk premia.
These indexes use transparent, rules-based methodologies based on key characteristics of individual risk factors. The starting point in their construction is market capitalization weights, which are then tilted slightly toward a specific factor. This approach emphasizes investability, rather than the pure exposure sought in more narrowly focused approaches to factor investing.
We assessed the risk indexes along the dimensions of risk, return, investability and diversification. The exhibit below shows key metrics for the simulated indexes during the period November 1992 to August 2012, using the constituents of the MSCI World Index as the investing universe. (This includes both large- and mid-cap stocks in developed equity markets. Our results for emerging markets, which we also evaluated, are generally consistent with the results for developed markets.)
Key Metrics of Simulated Factor Indexes and Combinations
Our study showed that, during this period, Value, Momentum, Low Size and Low Volatility all generated significant excess returns, relative to the market-cap-weighted MSCI World Index. For the November 1992 to August 2012 period, active annual gross returns (before costs) range from 65 bps annually for the World Low Size Tilt Index to 116 bps for the World Value Tilt Index. (Future results may differ materially.)
At the same time, the level of risk for the risk premia — whether measured by volatility, market beta or maximum drawdown — was similar to that of the World Index. (Of course, these historical data do not guarantee future outcomes.)
Investability was an important focus of our study. We found that several risk premia indexes offered the opportunity for strong investability, even for portfolios of considerable size (USD 100 billion or more). The more scalable indexes were Value, Low Size and Volatility. Momentum appears to be less scalable.
While the exhibit summarizes performance for the entire period studied, the factor indexes were subject to time variation, with all premia experiencing periods of weak performance. For example, Value and Low Size underperformed the market-cap benchmark over consecutive years. Value, Momentum and Low Volatility produced most of their excess return in the first half of the period studied, while the opposite was the case for Low Size.
We also observed that combining exposure to several factor premia at times provided substantial diversification benefits. In addition, their combination sometimes produced important cost benefits as crossing of trades between factors reduced portfolio turnover.
Read the paper, “Harvesting Risk Premia for Large-Scale Portfolios.”