By Pascal Blanqué
In a world of chasing returns, factor investing is gathering interest among institutional investors and asset owners. The current stage of a given risk factor’s lifecycle determines the degree to which the marketplace is aware of, and correctly pricing, the factor itself. This is a crucial aspect that long-term investors should consider when constructing their portfolios.
Asset prices correctly discount mature (or standard) risk factors such as size, value (Fama-French), liquidity and so on. The required rate of return of a stock takes into account its effective exposure to any of these factors, together with the factors’ risk premia. As an example, the required rate of return of an illiquid stock contains a component remunerating the risk of a late and costly execution. Similarly, the price of small capitalisation stocks discounts higher-than-average uncertainty about future cashflows, while the price of a “value” stock accounts for a higher-than-average risk of financial distress.
With respect to these mature risk factors, long-term investors can both build static and dynamic portfolios. The first approach recognises that factors’ returns are rather uncorrelated and thus a diversified (though inert) factor allocation significantly improves long-term risk-adjusted returns, compared to blended portfolios with no factor exposures.
An alternative approach is a dynamic allocation aiming to anticipate short and medium-term factors’ over and underperformance. In fact, similar to broad market risk, investors’ aversion to specific risk factors can vary over time, thus affecting asset prices. These changes in risk aversions however are highly dependent on financial markets’ regimes and macro-economic scenarios. Consequently, anticipating changes in market regimes or predicting the phase of the economic cycle represents a valuable factor timing tool that can ultimately deliver additional return.
Other risk factors have been investigated only in recent times. These emerging (or even latent) factors are characterised by a lower degree of awareness among investors, and are not fully priced yet.
Among these emerging sources of risks we find ESG-related and carbon-related factors. The former may refer to the risk of incurring material losses in cases of proved responsibility in environmental disasters, or the risk of fines for tax “over-efficiency”, or very low labour protection level. The latter rather refer to the link between CO2 emissions and the rising global average temperatures and the likelihood that new regulation will penalise the industrial sectors – and the specific companies – which are mainly responsible for these emissions.
With regard to these emerging risk factors, long-term investors should anticipate the decline in a stock’s price that occurs when the market’s awareness broadly increases, and the required rate of return adjusts accordingly: that is when the mispricing is finally corrected. Low carbon indexes are heading into that direction because, by reducing the carbon risks while keeping the same exposure to mature traditional factors, they generate a free option on a mispriced asset.
Pascal Blanqué is a member of the 300 Club and deputy CEO at Amundi
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