The Limitations of Factor Investing: Impact of the Volkswagen Scandal on Concentrated versus Diversified Factor Indices

Noël Amenc, Sivagaminathan Sivasubramanian, Jakub Ulahel: With recent developments in risk factor-based investing, many index providers, and more generally investment product providers, offer strategies that help investors gain exposure to various identified risk factors such as value, momentum and size, amongst others.

Author(s):

Noel Amenc

Professor of Finance, EDHEC-Risk Institute,CEO, ERI Scientific Beta

Sivagaminathan Sivasubramanian

Quantitative Analyst, ERI Scientific Beta

Jakub Ulahel

Quantitative Research Analyst, ERI Scientific Beta

While there is a consensus on the factors that are rewarded over the long term, it must be acknowledged that the implementation of factor investing, notably in the long-only universe, is not subject to the same consensus. Many commercial index providers aim to obtain strong exposure to risk factors through a stock selection that is often restrictive, resulting in relatively few securities in the portfolio in terms of the nominal number of stocks. Moreover, the weighting scheme applied to the stock selection is either market cap-weighting or score-based weighting, resulting in a very uneven distribution of weights. As a result, these indices are often very concentrated in a few stocks. Scientific Beta, on the other hand, has been advocating the benefits of diversification and all its factor indices are constructed to provide diversification in addition to the desired factor tilts. Volkswagen has been caught up in one of the most notorious scandals in corporate history by installing cheat software to reduce emissions during testing. The news broke on the eve of Friday, 18 September 2015 and the stock markets heavily penalised Volkswagen AG and other automobile stocks, including suppliers, on Monday, 21 September 2015. In the present study, we show that, in the month of September 2015, the impact of the Volkswagen scandal is much stronger in concentrated factor indices as opposed to Scientific Beta’s well-diversified smart factor indices which outperformed the cap-weighted benchmark. This better performance of the Scientific Beta Multi-Beta Multi-Strategy index is an illustration of the results of extensive research conducted by EDHEC-Risk Institute that shows that it is not enough to have a benchmark that is well diversified from a factor viewpoint, because it is allocated among several rewarded factors - one must also ensure that the specific risk of this benchmark is well diversified too. Merely working on the factor dimension of an index does not enable it to be qualified as smart.

Type: Working paper
Date: le 26/10/2015
Research Cluster : Finance

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