A long/short strategy could be applied to factors just as they it would be to individual securities.

Towards Purer Factors

In 1853, a French chemist by the name of Charles Frederic Gerhardt conducted an experiment in order to synthesise and describe the properties of various acid anhydrides.

He mixed acetyl chloride with sodium salicylate and was surprised to see a vigorous reaction which ultimately resulted in a solidified substance.

Gerhardt had just become the first chemist to prepare acetylsalicylic acid, the compound which would come to form the basis of a new wonder drug: aspirin.

The word aspirin refers to Spiraea, a biological genus of shrubs that includes the natural form aspirin’s key ingredient: salicylic acid.

This acid can be found in many plants, grasses and trees and its use has been known for a long time.

The ancient Egyptians used willow bark as a remedy for aches and pains, while the Greek physician Hippocrates also wrote about the effects of this bark.

Yet, as with many medicines, the drug works best when the key ingredient is isolated, which is why Gerhardt’s discovery was so important.

The idea behind factor investing is not unlike the process of isolating the working ingredients in medicine.

Investors and academics have been trying to work out why certain asset prices grow faster than others by isolating the drivers behind their investments.

Some of the best known drivers, or anomalies, include value, momentum, low volatility and carry, but many strategies that make use of these factors are still heavily exposed to the movements of the overall markets.

During a presentation at the recent i3 Portfolio Construction Masterclass in Fiji, AQR Capital Principal Gregory Andrade proposed to isolate factor strategies even further by applying some well-known hedge fund strategies to them.

Andrade took the example of an equity portfolio based on investment styles.

“It’s instructive to consider how a typical 60/40 portfolio of stocks and bonds is still highly dependent on equity risk. Most of the risk is dominated by equity beta; it is not as diversified as it could be.

“Such dependence on equity risk can leave a portfolio susceptible to equity market volatility and drawdowns. We believe investors can benefit by diversifying risk as much as possible to include alternative asset classes, like commodities and strategies such as long/short equity,” Andrade said.

A long/short strategy could be applied to factors just as they it would be to individual securities.

“Take the value factor for example. In a long-only construction, by only focussing on the cheap side you are getting only one half of the information. The information you have is not just that these stocks are cheap, but that the other stocks are expensive.

“It would be nice to do something with that. You can express this portfolio not only as a long-only value portfolio, but also as a long/short portfolio, where you are long the cheap stocks and short the expensive stocks.”

“In this way, you can exploit both sides of the idea, so you are not just making money buying cheap stocks, but also from shorting the expensive stocks,” he said.

“More importantly, by creating a long-short portfolio of certain styles or factors, you now have an uncorrelated source of return. You have turned this idea of applying styles into an alternative investment that sits in your portfolio as a diversifier, and diversification is very important” he said.