Market & Factor Volatility
Mirror, Mirror, on the Wall…
June 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Factor volatility mirrors market volatility
- Market volatility is higher than factor volatility
- Momentum has higher volatility than Value or Size
INTRODUCTION
The interest in factor investing is currently at an all-time high according to Google Trends, which is supported by an abundance of single or multi-factor products being issued, especially in the smart beta wrapper. While we are big believers in factor investing in general, it’s worth highlighting the risks associated with factor exposure. In this short research note we’re going to analyse factor volatility as a proxy for risk over time and compare it to equity market volatility.
METHODOLOGY
In order to get a meaningful snapshot of factor volatility we want to get the longest time series available and will therefore use Fama-French data, which is available from 1926 onward. It’s worth highlighting that this is a great free resource, however, the calculations are without transaction costs and include companies with very small market capitalizations that aren’t tradeable in reality. The long-short portfolios represent the bottom and top 30% of the stock universes.
US MARKET & FACTOR VOLATILITY (1926 – 2016)
The chart below shows the volatility of the equity market (long) and the three most researched factors: Value, Size, and Momentum (long / short) (read Size Factor). We can observe that the market has the highest volatility and Momentum the highest amongst factors. If an investor has factor exposure via smart beta products or equity market neutral portfolios, then a simple equal weighting might not adequately reflect the different risk profiles of the factors. A risk-weighted approach might be more reasonable, but higher volatility does not necessarily imply higher risks for each factor linearly, which is one of the complexities of factor investing.
