Factors are not always broad and persistent, but they can still be highly impactful on investors’ portfolios. It’s time to bring these factors back into risk models, Allspring Global Investments says
In investing, factors explain and identify the behaviour of assets, whether it is their potential return profiles, volatilities or their correlations with other assets. For factors to be recognised as such, they need to be proven to be persistent and work across multiple markets, or regions.
But not all factors follow this trajectory. Some might appear periodically and affect only a subsector of the market. Yet, when they appear they can quickly become the dominant driver of assets behaviour.
Wai Lee, Co-Head of Research for the Systematic Edge team at Allspring Global Investments, likes to call such factors ‘themes’. And he believes that many are missing from commonly used risk models.
Even though we all experienced in the markets a missing factor far more important than any of the risk model factors we subscribed to in driving the assets behaviour, it is not in the risk model vendor's best interest to incorporate it into their models because they knew such risk driver would eventually go away with COVID
“Themes are perceived trends that change the economies in certain ways by either changing or revising some business models,” Lee says in an interview with [i3] Insights.
“We, in the professional investment world, experience a lot of these transient factors in a small subset of or the whole assets universe, some evolved to become structural and universal. But even those that did not could be important.
“We think themes are the missing factors in your risk model,” he says.
Lee gives a recent example. “During COVID, we built a factor called the “stay-at-home” factor. [It was about] stay-at-home versus return-to-office,” Lee says.
“You didn’t hear about the stay-at-home factor in typical industry standard risk models that you subscribed to. And I think it is because, even though we all experienced in the markets a missing factor far more important than any of the risk model factors we subscribed to in driving the assets behaviour, it is not in the risk model vendor’s best interest to incorporate it into their models because they knew such risk driver would eventually go away with COVID,” he says.
Emerging Themes
A similar argument can be made about emerging factors before they have established themselves as structural driving forces. Although these factors are real and influence asset valuations, the fact that they haven’t been around for long means that there is little data to measure them with. Often this means they are overlooked in risk models.
“What is challenging about emerging themes is that you don’t have enough historical data to base estimations on. And we don’t know if these emerging themes are going to be transient or persistent, local to a subset or universal to all assets. So I think the key challenge to the investors is how do you deal with these themes?”
The rise of environmental, social and governance (ESG) score systems is a good example of a factor that has emerged in recent years and is now well on its way to become a structural influencer of stock behaviour.
“We have seen some stocks’ behaviour starting to evolve and that may be subject to how some of the ESG data providers score them and whether they receive a high score, or a low score. The assets start to behave in a different way, so some risk models start to incorporate this new factor,” he says.
Lee argues that investors should take a broad approach to factors and analyse whether their portfolios have any exposure to transient themes or emerging factors that can affect their holdings.
Lee sees the fundamental approach of working with themes as resource heavy with limited scalability or adaptability to work with multiple themes spanning across different regions, sectors and investment horizons. A rigorous systematic approach, therefore, could be complementary.
What is challenging about emerging themes is that you don't have enough historical data to base estimations on. And we don't know if these emerging themes are going to be transient or persistent, local to a subset or universal to all assets. So I think the key challenge to the investors is how do you deal with these themes?
One way to do this is by applying natural language processing (NLP) techniques to identify potentially impactful themes.
“We think NLP is particularly helpful to deal with emerging themes when it is even more challenging for us to quantify the exposure,” he says. “For example, we can use NLP to track how often a particular company filed for or was granted a patent.”
“Some [systems] look at company job postings and look at the profiles of the new hires. Some use NLP to analyse earnings calls, annual reports, or FOMC (Federal Open Market Committee) minutes.
“All this is really the first step to measure the intensity and the relevance of a particular concept,” Lee says.
Blending Themes and Its Implications for Asset Allocations
Once investors have identified which themes are likely to impact their portfolios, they then need to decide how to combine them in a portfolio, when certain themes can overlap, diversify, or neutralise their effect to such an extent that their combined portfolio impact can become amplified, enhanced, or muted.
“When we build the themes into a portfolio, we need to be factor aware,” Lee says. “We believe we should purge the exposures to other factors from a theme that you are interested in, almost like working with a purified theme.
“And then we can think about how to put them together taking into considerations interactions among themes as well as with other factors. There will still be some interactions, but at least we believe that this way will be more themes-focused and yet diversifying and risk-managed,” he says.
Predicting which theme will dominate during a certain time period is difficult, especially doing this on a consistent basis. Lee, therefore, suggests that investors may build in tilts or hedges to several themes into their portfolios as a core step.
“We have a menu [of themes], but we also keep track of the intensity of some of these themes. A theme that is mentioned more and more often may reflect higher potential to become a structural factor,” he says.
“But I like to have a core. It’s what I would consider as a starting point to invest. If I don’t have a strong view about which themes will become structural and enhance my performance, then I’d rather sit on multiple themes so that I have a chance to ride on whichever few become dominant. I don’t want to be left behind,” he says.
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