I watched my first Formula 1 race the other day.  I found the race to be much more interesting than the standard NASCAR events I’ve seen on tv since I was a kid.  In both motorsports risk plays a central role and the best drivers have a keen sense for balancing risk and reward.  The drivers that don’t take risks end up at the back of the pack while those that take too much risk end up crashing and dropping out of the race (without an injury if they are lucky!).

Just like good drivers, good investors understand how to appropriately balance risk and reward to achieve their goals.  Most investors eventually decide to allocate to some combination of market cap weighted equities and government bonds.  Without equity risk, investors likely won’t be able to achieve their goals.  However, too much equity risk and investors can crash and burn during an equity downturn.

The Equity Risk Premium

There is good reason for this.  Government bonds are referred to as the “risk-free” asset, as there is no default risk.  However, low risk is equal to low reward so most investors decide to allocate the majority of their capital to the higher risk and higher reward equity market in order to meet their goals.^[1]The AAII Asset Allocation Survey, shows that, on average since 1987, investors have allocated about 60% of their portfolios to equities. In doing so, investors have quite clearly decided that the excess return of equities is enough to compensate them for the additional risk.

The excess return of equities compared to bonds is called the Equity Risk Premium^[2]Per Dimson, Marsh and Staunton, “The formula is 1 + Equity rate of return divided by 1 + Riskless return, minus 1.” This can also be approximated by Equity rate of return less Riskless return. because this is the premium investors demand to take on the additional risk of equities compared to bonds.  A simple measure of the ratio of excess return to additional risk is called the Sharpe ratio.^[3]https://www.investopedia.com/terms/s/sharperatio.asp#:~:text=The%20Sharpe%20ratio%20is%20calculated,of%20the%20portfolio’s%20excess%20return.  Since 1871 the average US equity risk premium (excess annual return compared to US 10-year government bonds) has been 6.0% with a standard deviation of 19.5%. The excess return to risk (Sharpe) ratio is 0.31 (6.0% divided by 19.5%).^[4]Sharpe ratios are most often calculated using 30 day treasury bonds, but other treasury bonds can be used as well. Investors more typically choose to take some term risk so intermediate (10-year) … Continue reading

Factor Risk Premiums

Just as equity investors should demand a premium for the additional risk of equities compared to the alternative (bonds), long only factor investors should demand a premium for the additional risk of long only factors compared to the alternative (market cap weighted equities).

Just as we calculate an equity risk premium above, we can calculate a factor risk premium.  For example, since 1926 the average US value premium (excess annual return compared to market cap weighted equities) has been 3.0% with a standard deviation of 12.2%.  The excess return to risk ratio is 0.25 (3.0% divided by 12.2%). 

In order to consider an allocation to any of the factors, the factor risk premium should be comparable to the equity risk premium in terms of risk and reward characteristics.  Lucky for you, we have graphs to help us think about this!^[5]In what follows, factor risk premiums are compared to the equity risk premium to give us a better understanding of the risk and reward trade-offs factor investors are making.  All data is US … Continue reading

Balancing Risk and Reward

The below graph shows the excess return to risk ratios for each asset (blue columns, left hand side).  Also shown are the annual excess returns (green dot) and standard deviations (orange dot), which are plotted on the right hand side.

We can see that the factor risk premiums generally provide a similar trade-off between risk and reward as the equity (market) risk premium.  Logically, if investors have a preference for the equity risk premium, they should have a similar preference for the factor risk premiums.

Small stocks seem to have a slightly worse risk and return trade-off.  However, a common approach to factor investing is to target factors within the small cap universe, rather than the small factor itself.

We can see that all of the factor premiums within the small cap universe have offered a better risk and return trade-off compared to the equity risk premium.

Reliable Outperformance

Investors presumably prefer to invest in equities because, given a long time horizon, the equity market has reliably outperformed bonds.  The graph below shows the historical likelihood of each asset beating its relevant alternative over 1, 5, and 10 year holding periods.

Factor premiums (not including the small cap premium) were positive in more than 80% of all 10 year holding periods, measured using every starting month (vintage) for which data is available.  This is comparable to how often the equity premium is positive, which is also more than 80% of all 10 year periods.  

The small cap premium, although it was still positive in more than 70% of all 10 year periods, is a little less reliable than the equity risk premium.  If we look at the other factors within the small cap universe we get more reliable outperformance.

All factor premiums within the small cap universe reliably outperformed their alternatives over ten year holding periods.

Overall, the factors have outperformed equities just as reliably as equities have outperformed bonds.  

Large Total Premiums

Factor risk premiums are large, economically meaningful, and are similar in size to the equity risk premium.

The graph below shows the total premiums over 10 year holding periods.  The percentiles are based on every starting month (vintage) for which we have data.

By taking equity market risk, the most likely historical outcome over a 10 year period was a more than 40% increase in wealth compared to the alternative (bonds).  Median total factor premiums led to an increase in wealth of around 20-40% compared to the alternative (equity market).

The factor premiums exhibit less dispersion (more consistency) than the equity premium over a 10 year holding period.  The consistency of the profitability premium stands out, although this needs to be weighed against a smaller premium.

The small factor appears to be the most risky factor.  It is the only factor where the 20^th percentile 10 year total premium is negative, but targeting the other factors within the small cap universe has been well rewarded (as shown below).

Small cap factor investing has typically led to more than 50% higher wealth compared to the alternative (market cap equities) over 10 year holding periods.  The 10 year dispersion of outcomes within the small cap space is higher, but is still comparable to the dispersion of outcomes due to the equity premium.

In general total long term factor premiums are comparable to the total equity premium.  Wealth has increased substantially by investing in factors compared to their equity market alternative, just as investing in the equity market as a whole has substantially increased wealth compared to an investment in government bonds.

Worst Case Scenarios

With any investment, we should try to understand the potential worst case scenario.  The graph below shows the worst drawdowns the premiums have experienced. 

In every case, the factors have better drawdown profiles compared to their alternative (the market) than the market does to its alternative (10 year treasuries).  Profitability, Investment and Momentum have limited drawdowns in this context, almost never entering a bear market (20% drop) relative to the equity market as a whole.

The drawdowns for the small cap factor premiums are more severe, which is indicative of their higher volatility compared to their large counterparts above.  Even so, we see the same pattern, less severe drawdowns for factor premiums compared to the drawdowns of the equity premium.

Summary of Equity vs. Factor Premiums

It is very common for investors to look at the risk and return characteristics of equities compared to their main alternative, intermediate government bonds.  Most investors conclude that the equity market offers a worthwhile tradeoff between risk and reward.  Investors therefore typically allocate most of their portfolio to equities.

Equity factors, compared to their alternative (the equity market generally), have similar risk and reward characteristics as the equity market, compared its alternative (bonds).  In comparison to the equity risk premium, factor premiums have had similar risk adjusted excess returns and similar total premiums over long holding periods.  Factor premiums have been as reliably positive as the equity risk premium over various holding period and have exhibited comparatively smaller drawdowns.

Investors who agree that the risk/return profile of the equity market is favorable compared to government bonds should also conclude that the risk/return profile of factors is favorable compared to the equity market as a whole.  Prudent investors should therefore consider allocating at least a portion of their portfolio to factors.

Choosing the Best Premium for You

In NASCAR all of the vehicles are essentially the same.  They all have the same engine and the same frame.  The race is a lot of laps around an oval track with the same turn every time.  Any differences in performance can mostly be attributed to the actions of the driver.

In F1 all of the vehicles are uniquely designed by each team and are custom built for the specific course and race.  There is much more variety in the types of twists, turns, and curves that the vehicles have to be prepared for.  The actions of the driver are still important, but the design of the vehicle also makes a big difference.

Both motorsports have similarities to equity investing, with NASCAR, just like with traditional market cap weighted investing, you know what you are getting.  The performance is more predictable and you don’t have much risk of being different.  In F1, just like with factor investing, there is inherently less predictability.  Investors have to balance the risk of a different investing vehicle with the potential rewards for doing so.  There is more customizability as well.  You can design your portfolio to more safely and consistently handle the twists and turns of the market environment (profitability) or aim for maximum straight line speed (small value).

With both forms of investing, just as with both motorsports, the actions of the investor (driver) are hugely important, consistency is key, and maximizing rewards for the risks you are taking is the key to success.  

Just as neither sport is necessarily better than the other, neither form of investing is necessarily better than the other.  It is up to each investor to decide which portfolio gives them the best chance of handling the turns of the market.  Factor Graphs offers a number of tools to help you choose a portfolio that allows you to navigate the long race ahead.