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Factor Investing and Adaptive Skill: 10 Observations on Rules-Based Equity Strategies

Mike Sebastian and Sudhakar Attaluri
The Journal of Investing Spring 2016, 25 (1) 95-102; DOI: https://doi.org/10.3905/joi.2016.25.1.095
Mike Sebastian
is a partner and head of the Global Investment Committee at the Aon Center for Innovation and Analytics in Singapore.
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  • For correspondence: mike.sebastian@aonhewitt.com
Sudhakar Attaluri
is an associate partner at Aon Hewitt in Chicago, IL.
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  • For correspondence: sudhakar.attaluri@aonhewitt.com
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Abstract

There are many varieties of rules-based, or smart beta, equity strategies. In this article, we provide 10 insights that focus on the equity strategies that are currently the most commonly used among institutional investors: fundamental and low volatility. Rules-based strategy returns are largely driven by exposure to equity risk factors—especially value, small, and low volatility—but also momentum, quality, and several others. Several factors have produced above-market returns in the past, and there is reason to expect that they will do so over sufficiently long periods of time in the future. Factors will go through long periods of underperformance and require close monitoring. There are several ways to potentially profit from factor premiums, including traditional active strategies, timing strategies, and rules-based strategies. Using adaptive skill that adjusts strategy based on complex and changing market conditions is still the best way to exploit market inefficiencies. Asset allocation, not equity strategy, remains the most impactful portfolio decision. The right equity portfolio is dependent on an investor’s suitability factors, which include return objectives, tolerance for risk and cost, and oversight resources. Rules-based strategies are most attractive for investors with cost constraints, aversion to significant active risk from concentrated portfolios, or a desire to reduce market exposure at relatively low cost in the medium or long term through low-volatility investments.

TOPICS: Analysis of individual factors/risk premia, equity portfolio management, performance measurement

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The Journal of Investing: 25 (1)
The Journal of Investing
Vol. 25, Issue 1
Spring 2016
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Factor Investing and Adaptive Skill: 10 Observations on Rules-Based Equity Strategies
Mike Sebastian, Sudhakar Attaluri
The Journal of Investing Feb 2016, 25 (1) 95-102; DOI: 10.3905/joi.2016.25.1.095

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Factor Investing and Adaptive Skill: 10 Observations on Rules-Based Equity Strategies
Mike Sebastian, Sudhakar Attaluri
The Journal of Investing Feb 2016, 25 (1) 95-102; DOI: 10.3905/joi.2016.25.1.095
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  • Article
    • Abstract
    • 10. RETURNS TO RULES-BASED INVESTING ARE MOSTLY DRIVEN BY EXPOSURE TO FACTORS
    • 9. CERTAIN RISK FACTORS HAVE OUTPERFORMED IN THE LONG RUN
    • 8. FACTOR OUTPERFORMANCE IS DRIVEN BY MARKET MISTAKES AND RISK
    • 7. MANY RISK FACTOR RETURN PREMIUMS HAVE SURVIVED FOR A LONG TIME—BUT THEIR VITAL SIGNS NEED ONGOING MONITORING
    • 6. FACTOR STRATEGIES GO IN AND OUT OF FAVOR; BE DYNAMIC OR IN FOR THE LONG HAUL
    • 5. THERE ARE SEVERAL POSSIBLE APPROACHES TO FACTOR INVESTING; A TYPICAL INSTITUTIONAL PORTFOLIO PROBABLY ALREADY EMPLOYS AT LEAST SOME OF THEM
    • 4. VIRTUALLY ALL INVESTMENTS ARE ACTIVE IN SOME WAY; THUS, INVESTORS SHOULD SKIP THE DEBATE, MEASURE THEIR ACTIVE RISK, AND MAKE SURE THEY ARE BEING COMPENSATED FOR IT
    • 3. NOT ALL SMART BETA IS CREATED EQUAL; CAREFULLY REVIEW THE RISK EXPOSURES OF THE SPECIFIC STRATEGIES CONSIDERED
    • 2. ADAPTIVE SKILL IS THE BEST WAY TO OBTAIN POTENTIALLY ABOVE-MARKET RETURNS
    • 1. THE RIGHT PORTFOLIO DEPENDS ON INVESTOR SUITABILITY FACTORS THAT INCLUDE RETURN OBJECTIVES, TOLERANCE FOR RISK AND COST, AND OVERSIGHT RESOURCES
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