Factors & Volatility-Based Risk Management

Different Factor, Different Risk Management?

July 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • A common approach to factor allocation is to scale exposure by factor volatility
  • This approach improves the risk-return ratios of Momentum, but lowers them for Value and Size
  • Factors have different underlying drivers, which require different risk management systems

INTRODUCTION

Factors, like equity markets, can have significant multi-year drawdowns. Investors therefore have been researching how to mitigate the drawdowns given substantial career risks. One common approach is to scale the exposure to a factor by its volatility. Although this might be a useful concept from a portfolio perspective (aka risk parity), we believe this approach does not work well for factor allocations as it does not improve the Sharpe ratios of factors on average. The relationship between return and volatility is not linear, which might be explained by factors having different drivers. In this short research note we will analyse factor volatility as a risk management tool for factor allocations (read Market Timing vs Risk Management).

METHODOLOGY

We will use Fama-French data for this analysis as it offers the longest data history. We will focus on the Value, Size, and Momentum factors and use the top and bottom 10% of the US stock universe, where data is available since 1926. Factor volatility is calculated over a 3-month period and the history is expanding over time in order to avoid any look-ahead bias. The risk management model is constructed as simple as possible: if factor volatility is in the top quartile, then go into cash, otherwise stay fully invested.

VALUE FACTOR (LONG / SHORT): PURE VS VOLATILITY-ADJUSTED

The chart below shows the performance of the Value factor in the US from 1926 to 2016, once pure and once volatility-adjusted. The flat lines of the volatility-adjusted factor represent periods where the factor volatility was high and the allocation was reduced to zero. The analysis shows that the risk management system led to a lower performance over the entire period. It’s worth highlighting that the volatility-adjusted factor is only invested 80% of the time and could earn interest