Can you help me understand this paper? Factor premia by Scot & Cavaglia

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
YRT70
Posts: 172
Joined: Sat Apr 27, 2019 8:51 am

Can you help me understand this paper? Factor premia by Scot & Cavaglia

Post by YRT70 » Mon Jun 10, 2019 10:50 am

I'm reading a paper on factor premia. This one: https://jpm.iijournals.com/content/43/3/33

I'd like to understand how they built their portfolio. Maybe I'm overlooking something but it seems that they only speak of adding an overlay but don't describe how they did it. For example: Is the second portfolio 50% total market, 50% small caps?

Image

"The analysis presented in this section should be viewed as descriptive; in the next section of the article, we use a utility-based framework to evaluate the results presented here in. Block bootstrap simulations are used to generate alternative histories for the market and our four factor premia. These histories can be used to generate terminal wealth distributions from investing $1 across alternative investment strategies over a 20-year horizon.8 The strategies we consider are an investment in the global equity market, an investment in the global market complemented by an overlay in one risk premium (each considered independently), and an investment in the market complemented by an overlay of an equal- weighted allocation to each factor premia. In Exhibit 2, we present select percentiles for the empirical distribution of terminal wealth for our candidate strategies. We note, for instance, that $1 invested in the market grows to a median value of $4.15 by year 20. Approximately 5% of the time, the investor will end up losing part of her initial capital; the 5th percentile of terminal wealth shows a value of $1.06.9 If our investor is extremely fortunate, she will increase the value of her investment by more than twentyfold with about 1 in 100 odds. If we consider adding a single premium overlay to our baseline equity strategy, we note that we enhance the distribution of terminal wealth. The median value of our investment rises from $4.15 (base case) to a range of $4.86 (global equities plus the small-cap overlay) to $16.13 (global equities plus the momentum overlay). "

pkcrafter
Posts: 13392
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: Can you help me understand this paper? Factor premia by Scot & Cavaglia

Post by pkcrafter » Tue Jun 11, 2019 5:31 pm

Thanks for posting this information. Here's a bit more.
This paper confirms the importance for investors to be exposed to certain factor premia (value, size, momentum, quality). In fact, it shows that an equal allocation to these four premia on top of a global equity portfolio: 1) enhances the probability to reach retirement goals, 2) mitigates drawdowns in the journey to retirement.
https://www.valuewalk.com/2017/06/acade ... etirement/

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

Topic Author
YRT70
Posts: 172
Joined: Sat Apr 27, 2019 8:51 am

Re: Can you help me understand this paper? Factor premia by Scot & Cavaglia

Post by YRT70 » Sat Jun 15, 2019 1:15 pm

pkcrafter wrote:
Tue Jun 11, 2019 5:31 pm
Thanks for posting this information. Here's a bit more.
This paper confirms the importance for investors to be exposed to certain factor premia (value, size, momentum, quality). In fact, it shows that an equal allocation to these four premia on top of a global equity portfolio: 1) enhances the probability to reach retirement goals, 2) mitigates drawdowns in the journey to retirement.
https://www.valuewalk.com/2017/06/acade ... etirement/

Paul
Thanks for your reply Paul. I had not noticed it before. I'll read that link now.

I've also noticed an article by Larry that explains it in a bit more detail:
https://thebamalliance.com/blog/managin ... h-factors/
They then used these histories to generate terminal wealth distributions from investing $1 across alternative investment strategies. The alternative investment strategies they considered were an investment in the global equity market, an investment in the global market complemented by an overlay in a risk premium (each factor considered independently), and an investment in the market complemented by an overlay of an equal-weighted (1/N) allocation to each factor premia.

In the case of a single factor, the overlay is $1 invested in the long side of the premium and $1 invested in the short side. In the case including all four factors, each factor has $0.25 invested in the long side and $0.25 invested in the short side. The portfolios were rebalanced monthly.
If anyone can translate that into layman's terms I'd be thankful. I don't know how that portfolio would look like.

garlandwhizzer
Posts: 2285
Joined: Fri Aug 06, 2010 3:42 pm

Re: Can you help me understand this paper? Factor premia by Scot & Cavaglia

Post by garlandwhizzer » Sat Jun 15, 2019 9:52 pm

Both Scot and Cavaglia work for investment firms. I'm sure they'd be willing to clear up any confusion and put you into products that work well using their backtesting models. Whether or not that will improve your portfolio outcomes is IMO not predictable. It's very easy using backtesting to optimize a portfolio with what has done best over any time period in the past. Whether it will do best going forward is a entirely different question. Maybe, maybe not.

Garland Whizzer

Topic Author
YRT70
Posts: 172
Joined: Sat Apr 27, 2019 8:51 am

Re: Can you help me understand this paper? Factor premia by Scot & Cavaglia

Post by YRT70 » Sun Jun 16, 2019 10:42 am

garlandwhizzer wrote:
Sat Jun 15, 2019 9:52 pm
Both Scot and Cavaglia work for investment firms. I'm sure they'd be willing to clear up any confusion and put you into products that work well using their backtesting models. Whether or not that will improve your portfolio outcomes is IMO not predictable. It's very easy using backtesting to optimize a portfolio with what has done best over any time period in the past. Whether it will do best going forward is a entirely different question. Maybe, maybe not.

Garland Whizzer
Thanks Garland. I'll send them an email. It wasn't exactly back testing that they used:
The authors used a bootstrapping technique (rather than a Monte Carlo simulation) to simulate returns in a way that preserved the autocorrelation observed in markets. They used the bootstrap simulations to generate alternative histories for the market and the four factor premiums.

Post Reply