Factor Exposure Analysis: Dow Jones

Dissecting the Dow

March 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Factor exposure should be considered a source of returns as well as of risk
  • Factor biases can be measured top-down or bottom-up
  • The results of the two approaches do not necessarily reconcile

INTRODUCTION

Factor investing has become immensely popular in recent years and assets in smart beta products surpassed $1 trillion in 2017. However, factor exposure should be regarded as much as a source of returns as of risks because factor performance is highly cyclical with some factors exhibiting significant multi-year drawdowns. Some investors prefer to avoid large factor biases in their portfolios, which requires an assessment of the factor exposure. In this short research note we will highlight the two primary approaches for measuring factor exposure, which are regression and ranking-based methodologies, and will take the Dow Jones Industrial Average as a proxy for a simple stock portfolio (read Smart Beta & Factor Correlations to the S&P 500).

METHODOLOGY

We focus on analysing the exposure to seven factors namely Value, Size, Momentum, Low Volatility, Quality, Growth and Dividend Yield. These are created via long-short beta-neutral portfolios based on the top and bottom 10% of the US stock market. Only stocks with a market capitalisation of larger than $1 billion are included. Portfolios are rebalanced monthly and each transaction occurs costs of 10 basis points.

We apply two methodologies for measuring the factor exposure of a stock portfolio:

  1. Regression-based (top-down): The returns of the portfolio are regressed against the factor performance with a one-year lookback period
  2. Ranking-based (bottom-up): Each stock is ranked on each factor relative to all other stocks and then assigned a ranking score, which is then aggregated on portfolio level for each factor

DOW JONES CHARACTERISATION

In advance of the analysis it is worth highlighting that the Dow Jones is a reasonable example of a common stock portfolio given 30 well-known constituents; however, not a well-designed index. The index weights are based on stock prices as compared to the more accepted