A Novel Template for Understanding Priced Factors

Abstract

Asset managers are increasingly incorporating equity factors that deviate from traditional academic definitions in their stock selection process. We show that these factors frequently exhibit strong industry biases, making it crucial to understand the interaction between factor exposure and traditional industry exposure. Industry exposure plays a major role in the risk profile of a portfolio, making unintended industry exposures costly. For an extensive set of 21 equity factors, beyond the standard academic factors, we examine which equity factors are rewarded for their industry allocation. This set spans the value, quality, momentum, low volatility, and size investment styles. We use a global and liquid investment universe, as is commonly used by large institutional asset managers. We find that equity factors from the same investment style, most notably momentum and quality, exhibit strong differences in their returns from industry allocation. Understanding the interaction between factors and industry exposures can lead to higher return premiums, and lower portfolio volatility without harming performance.