Portfolio Management: The Importance of Controlling Exposures to Equity Risk Factors

Controlling exposures to equity risk factors is an important part of portfolio management. Investment factor analysis can help investors navigate uncertain markets and capture opportunities.

Measuring portfolio factor exposures is a practical guide to risk-based investing, which views a portfolio as a collection of return-generating processes or risk factors.  Knowing and managing portfolio exposures to equity risk factors is an important aspect of investment decisions for growing and preserving capital as it is widely acknowledged that equity risk factors explain the majority of the return in equity portfolios.

Equity Risk Factors

Equity risk factors are the primary drivers of stock and portfolio returns, and can be targeted through factor investing.

The return obtained through exposure to the equity market is defined as Equity Risk Premium and the return obtained through exposure to individual risk factors is defined as Factor Risk Premium. Factor risk premium combined with non-factor risk premium equals equity risk premium.

Common equity risk premia factors include Value, Size, Volatility, Dividend Yield, Quality and Momentum etc.  Each factor class contains a number of metrics that capture the factor effect and it is standard practice to combine two or more simple factors to create a composite factor to capture factor risk premia in a more consistent manner e.g. Book to Price and Earnings to Price are widely used Value factors and combining the two creates a composite Value factor.

A factor for which a positive risk premia exists is called a compensated factor.  It means that exposure to a compensated factor can expect to earn a positive return in the medium to long-term, and examples of compensated factors are Value, Quality, and Momentum.  Factors that deliver no positive risk premia are uncompensated factors, examples of which are Market Beta and Residual Volatility.

Factor Exposure Analysis

Factor exposure analysis is a framework used to analyse the risk factor diversification of a portfolio.  It involves measuring a portfolio or security’s exposure or sensitivity relative to an investment universe to construct an assessment of how exposed it is to any particular factor.  Investors control their portfolio return by controlling portfolio exposures to equity risk factors.

There is no good or bad exposure, only intended and unintended exposure.  Unintended factor exposures occur as a result of the security selection process.  At any given point in time, only a handful of securities exist whose specific element has a stronger influence than its exposures to equity risk factors.  

A diversified portfolio whose exposures to an entire spectrum of risk factors are neutral relative to its benchmark, will generate portfolio return in line with the benchmark. This is because security specific risk is an uncompensated risk and can be diversified away, and hence will not deliver positive risk premia. Similarly, a diversified portfolio with material tilts to a spectrum of risk factors will have the majority of its return dictated by these factors, with security specific stories explaining minimal return.

Managing Factor Exposures

In conclusion, managing exposures to equity risk factors is a powerful framework by which investors can make informed investment decisions, minimise return surprises, and ultimately achieve their investment goals.

A comprehensive factor analysis of the portfolio provides insights into its key exposures and helps to avoid unintentional factor bets and thereby ensures alignment of factor exposures with investment objectives. In summary, a disciplined approach to managing factor exposures can help investors navigate uncertain markets and capture opportunities.

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