Popular factor analysis tools lead investors to dangerous allocation mistakes
In a new research publication, ERI Scientific Beta, the leading smart beta index provider, and Scientific Analytics, EDHEC Business School's new venture dedicated to factor analysis and allocation, have studied popular factor analysis tools available on the market.
The decision to write this white paper was stimulated by the appearance of new factor box tools promoted by investment market leaders as factor risk analysis standards. After serious analysis of these tools, the authors consider that they are not based on an academic state of the art and that their use can lead to serious misalignment between an investor's factor diversification objectives and the measured and realised allocation.
This research paper, entitled Measuring Factor Exposure Better to Manage Factor Allocation Better: A Critical Approach to Popular Factor Box Initiatives, is accessible through the following link:
It contains two main contributions, one entitled Exposed to Nonsense? Spurious Factors in Popular Investment Tools and the other entitled Mismeasurement of Factor Exposures in Score-Based Analytics Tools. These two contributions lead to clear conclusions:
Analytic tools do not employ academically-grounded factors and their factor-finding process maximises the risk of ending up with false factors;Non-standard factors lead to mismeasurement of exposures and may capture exposure to redundant factors;The use of factor scores instead of factor betas for the measurement of portfolio factor exposures is a cause for concern because factor investing literature uses beta-based models for factor premia tests and for portfolio style analysis;The major drawback factor scores suffer from is double counting of exposures, which is due to their lack of regard for the correlation structure of factors. This makes factor scores a very poor proxy for factor betas;
These limitations can lead to investors being unable to translate their risk allocation choices into a consistent allocation, with fairly severe financial consequences.
As part of its policy of transferring know-how to the industry, EDHEC-Risk Institute has set up ERI Scientific Beta. ERI Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in smart beta design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks.
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