Factor Investing in South Africa

Abstract

Risk factors and systematic factor strategies are fast becoming an integral part of the global asset management landscape. In this report, we provide an introduction to, and critique of, the factor investing paradigm in a South African setting. We initially discuss the general factor construction process at length and construct a comprehensive range of risk factors for the South African equity market according to international factor modelling standards. In this report, we focus on the size, value, momentum, profitability, investment, low volatility and low beta risk factors respectively. We critically examine the historical behaviour and robustness of these factors, paying particular attention to the issues of long-only versus long/short factors, the impact of size, the effect of rebalancing frequency and data, and the robustness of performance to alternative factor definitions.We also review how these factors can be used generally in risk management and portfolio management. In the risk management space, we firstly consider risk attribution to factors and introduce the Factor Efficiency Ratio as a means of quantifying a fund’s desired versus undesired factor exposure. Secondly, we consider returns-based style analysis as a means of identifying a fund’s factor style mix and also as a method for replicating existing indices with long-only risk factors. In the portfolio management space, we discuss several approaches for creating multi-factor portfolios. We start by considering the simplest case of portfolio mixing, which allocates to a set of predefined factor building blocks. We then review the integrated scoring approach, which accounts for multiple factors within the scoring process directly. Finally, we consider a mixed integer programming optimisation approach, which allows an investor to construct an optimal multi-factor portfolio that is as consistent with their return objectives and risk preferences as their constraint set will permit.