IPE Webinar – Choosing Factors: Not Which But When by Northern Trust Corporation
Michael Hunstad, PhD Head of Quantitative Research, Global Equity
- Michael leads Quantitative research within the Global Equity Team.
- Michael has been with Northern Trust since 2012 and has 15 years industry experience.
- He holds a PhD in applied mathematics as well as an MBA in quantitative finance and an MA in econometrics.
Meggan Friedman, Senior Investment Strategist, Global Equity
- Meggan helps to create current thought leadership for global investors and to deliver comprehensive investment solutions across the equity spectrum.
- Meggan has been with Northern Trust since 2011 and has 19 years of industry experience.
- Meggan has a bachelor degree from Northwestern University and an M.B.A from Harvard Business School.
- Meggan was named “Best on the Street” by Wall Street Journal in 2010 and 2011.
Factors – the Free Lunch?
Style factors have generated greater absolute and risk-adjusted returns relative to standard indices over the long-term.
Sustained underperformance is a primary risk in factor investing
Each month from January 1979 to June 2014 all stocks in the Russell 3000 universe were ranked on the MSCI Barra definition of Value and put into equally weighted quintiles. The subsequent return for each quintile is computed with the resultant value factor return defined as the first quintile (highest value) return minus the benchmark return.
The value cycle lasts for approximately 47 months
The length of underperformance is not consistent across factors
Return series for each factor are computed in a manner similar to the previous slide (value factor). Each month from January 1979 to June 2014 all stocks in the Russell 3000 universe were ranked on the MSCI Barra factor definition and put into equally weighted quintiles. The subsequent return for each quintile is computed with the resultant factor return defined as the first quintile (highest value) return minus the benchmark return. Spectral analyses, i.e., cycle lengths, were computed using a Fast Fourier Transform.
The impact of factor cycles can also be analyzed in an asset allocation context
Not ‘Which?’ but ‘When?’
The optimal equity factor depends on the intended holding/evaluation period
RULE OF THUMB: The intended holding/evaluation period should be twice the cycle length.*
This rule implies the standard deviation of individual factor cycles are roughly one half the cycle length which is broadly supported by the empirical data. This suggests the rule of thumb will be roughly 95% accurate
See full PDF below.