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Equity factors for multi-asset class portfolios: a strategic asset allocation perspective

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Abstract

This paper highlights the long run, strategic benefits of factor premia as a complement (overlay) to an underlying exposure to equities and bonds. We provide a utility-based framework for evaluating alternative strategies and in particular account for the impact of extreme and undesirable events to long run wealth accumulation. We present evidence suggesting that an overlay of equity premia to a reference portfolio can enhance the likelihood of achieving wealth accumulation goals and can smooth the transition path to achieving those goals. These results can be attributed to both long positions and short positions in contrast to recent findings suggesting shorts fail to add value. The benefits of the factor premia overlay additionally extend to the decumulation or retirement stage as reflected in an enhancement to the coverage ratio. Taken together, these findings suggest that the equity factor premia strategies we present can be utilized to support welfare enhancing gains.

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Notes

  1. For instance, investors may be restricted from shorting and hence may be constrained into a long only exposure to factors.

  2. Intertemporal Capital Asset Pricing Model (ICAPM).

  3. Mean-variance efficient (MVE).

  4. To the best of our knowledge the total portfolio framework was first introduced by Don Raymond (2009) and represents Cochrane’s (1999) formulation of multi-factor investing as overlaying factor exposures and alpha exposures onto a reference portfolio.

  5. These constructs can be easily implemented with futures. For instance, for $100 of initial investment $10 are used to buy futures on margin providing a notional exposure of $100 to the base asset. The remaining $90 can be invested in a long/short strategy that could exhibit varying leverage; for simplicity we assume the total long/short gross exposure to be either $300 (for the 200/100) or $160 (for the 130/30).

  6. Scott and Cavaglia (2017) provide a more technical motivational and methodological expose of the block bootstrap approach. In their 2017 study they use quarterly data blocks. Our results are not overly sensitive to alternative blocks sizes of up to 12 months. Politis and Romano (1992) and Politis (2003) provide relevant analytical foundations.

  7. The CRRA of 2 has the functional form U = {1-exp(-2w)}/w. The expected utility E(w) can then be used in the inverse function of the CRRA to obtain the CE.

  8. Returns are reported gross of transactions costs and borrow costs; the analysis of Briere et al. (2020) suggests that factor-based strategies can be scaled significantly by effective management of these costs.

  9. The commodity market is proxied by the S&P GSCI index, the equity market is proxied by the MSCI World index, and the bond market is proxied by the World Government Bond index (WGBI).

  10. De Longis (2019), De Longis and Ellis (2019), and Polk et al. (2020) provide an extensive discussion of the methodology for identifying the state variables and their economic interpretation.

  11. The ubiquitous equity value premium provides an interesting illustration of our insight. The long only MSCI World value index for the period 1974 to present has not exceeded the return on the market. However, over this same period the Fama-French Long/Short value factor portfolio has returned 2.7% per annum. This has been labelled in the empirical finance literature as the “transfer” loss; in this case it is material.

  12. We are grateful to Alessio De Longis for guiding us through these observations.

  13. These qualitative conclusions hold as well for the 130/30 strategy.

  14. The 130/30 strategies result in much small marginal increases in volatility of 0.03% for equities and 0.06% for bonds.

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Authors and Affiliations

  1. State of Wisconsin Investment Board, 121 East Wilson Street, Madison, WI, 53707, USA

    Stefano Cavaglia

  2. Alphidence Capital, 29 Farm Street, London, W1J 5RL, UK

    Louis Scott

  3. Global Thought Leadership at Invesco, 100 Federal Street, 28th Floor, Boston, MA, 02110, USA

    Kenneth Blay

  4. Managing Director of Research and Global Head of Investment Technology, 225 Liberty Street, New York, New York, 10281, USA

    Tarun Gupta

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  1. Stefano Cavaglia
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  2. Louis Scott
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Correspondence to Stefano Cavaglia.

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This paper was completed prior to Stefano Cavaglia joining SWIB and while he was employed at Virtual Asset Management (VAM), Sydney. The views presented in the paper do not necessarily reflect the views of the State of Wisconsin Investment Board.

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Cavaglia, S., Scott, L., Blay, K. et al. Equity factors for multi-asset class portfolios: a strategic asset allocation perspective. J Asset Manag 23, 100–113 (2022). https://doi.org/10.1057/s41260-022-00262-4

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