Risk-Based and Factor Investing, edited by Emmanuel Jurczenko, presents recent advances in a major field of the asset management industry, namely portfolio construction techniques that do not rely on expected returns. Expected returns are known to be difficult to measure and often result in mean-variance allocations with extreme and unrealistic weights. The book is organized in 20 chapters written by leading academics and practitioners, combining both theoretical and empirical aspects.
As its tittle suggests, the book is organized along two lines. In the first part, the book provides a comprehensive analysis of risk-based investing, which is a portfolio construction approach that aims at controlling for the total risk of the constructed portfolio without any consideration for the expected return. Instead, portfolio weights are determined using specific rules describing the contribution of the assets to the total risk of the portfolio. Examples of such rules are: minimum variance, equal weighting, equal risk contribution (risk parity), or maximum diversification. The choice of a given risk-based rule can be driven by the information available or the conviction of the investor regarding the volatilities of the assets and their correlations. Risk-based investing is widely used in asset management for more than a decade, in particular since the 2008 crisis. Its success can be explained by the fact that it is easy to implement and does not rely on expected returns. In addition, its overall performance has been relatively good in the recent period, in particular because it has benefited from the over-performance of low-risk stocks.
In the second part, the book analyses factor investing, which tries to understand (and benefit from) the sources of the risks underlying the portfolio. Several anomalies have been identified such as size, value, momentum, low-volatility, or low-beta anomalies. For instance, the low-volatility anomaly indicates that low-volatility stocks outperform high-volatility stocks on a risk-adjusted basis. This over-performance can be captured by investing in a self-financed portfolio that is long the low-volatility stocks and short the high-volatility stocks. Low risk (low volatility or low beta) factors are particularly attractive in the context of the book as they can be directly connected to risk-based approaches. The recent growing popularity of factor investing in asset management is related to a better understanding of the systematic strategies. Risk-factor driven investment strategies (often called smart beta) have been developed by asset managers to capture the risk premium of a given source of risk, such as the low-risk strategy. The availability of factor indexes allows investors to manage their portfolio in a passive way while extracting the risk premiums embedded in the factors. As Bender et al. (Chapter 15) state, “factor index-based investing can be viewed as active decisions implemented through passive replication”.
In addition to a comprehensive description of the risk-based and factor-investing approaches, the book also presents recent advances in both fields. Contributions to risk-based investing mainly follow two directions. First, the various diversification rules mentioned above can be encompassed into a more general risk-based investing framework. In Chapter 2, Richard and Roncalli show that these rules can be written as a portfolio variance minimization problem with different sets of diversification constraints. In Chapter 6, Jurczenko and Teiletche describe a generalized approach that allows the investor to take account of additional risks (such as asymmetry, tail, or illiquidity). The second route, followed by Darolles, Gouriéroux, and Jay (Chapter 5), consists in robustifying the portfolio allocation by introducing some changes in the portfolio construction problem: (1) the risk of the portfolio can be measured by its Value-at-Risk instead of its volatility, to take extreme risks into account; (2) the risk contribution of the various assets to the portfolio risk can be restricted to its systematic component. These contributions considerably extend the scope and applicability of risk-based rules.
Recent advances in factor investing are mainly focusing on the allocation process based on factor indexes. A first extension of the smart beta investing is the multi-factor index allocation. As illustrated by Bender et al. (Chapter 15), by combining several factors into a single multi-factor index, this approach is designed to reduce the sensitivity of the portfolio performance to the macroeconomic cycle. In a second extension, Amenc et al. (Chapter 17), smart factor indexes are used as building blocks of an efficient allocation, which allows several risk premia to be efficiently captured. In Chapter 8, Boudt et al. propose another approach to enhance the performance of the factor-investing approach. Tactical investment rules allow the investor to switch to cash investment in market downturns, using a regime-switching model with macro-financial variables driving transition probabilities.
Clearly, risk-based and factor-investing approaches are not independent from each other. The construction of smart-beta portfolios in fact often corresponds to specific targets in terms of volatility reduction, as shown by Richard and Roncalli (Chapter 2). Investment strategies based on the low-risk anomalies, analyzed by De Carvalho et al. (Chapter 11) and Hsu and Viswanathan (Chapter 12), are close in spirit to risk-based investing. In Chapter 18, Luo and Mesormeris suggest that in fact both approaches could be combined in portfolio construction. Factor investing is about the selection of the risk factors, whereas risk-based portfolio construction technique represents an optimal way to combine the risk factors.
This book is a state-of-the-art analysis of two hot topics in portfolio construction. It proposes new insight about risk-based and factor investing. In addition to the methodological contributions, the book also provides an extensive empirical analysis of these approaches over the recent period.
Éric Jondeau
University of Lausanne and Swiss Finance Institute
