Should Equity Factors Be Betting on Industries?

Abstract

Asset managers are increasingly incorporating equity factors that deviate from traditional academic definitions in their stock selection process. The authors 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, the authors examine which equity factors are rewarded for their industry allocation. This set spans the value, quality, momentum, low-volatility, and size investment styles. The authors use a global and liquid investment universe, as is commonly used by large institutional asset managers. They 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. Key Findings ▪ Asset managers are increasingly using nontraditional equity factors to select stocks. Many of these factors have biases toward and away from certain industries. ▪ Some equity factors are rewarded for industry exposure; for others, this is an unrewarded risk. We assess industry allocation efficacy for 21 equity factors. ▪ Industry allocation efficacy differs significantly across equity factors, even among factors associated with the same investment style.