10 Jul Industry Factor Portfolios with Structural Advantage
- The Food and Healthcare factor portfolios generated structural alpha at risk levels comparable to the U.S. market over a long time period.
- The Technology return is attributable to structural beta over the long-term. Since 2009, Technology return is tantamount to a levered market portfolio.
- Energy return is attributable to structural beta over the long-term.
Investors know that factor exposures embedded in portfolios are the major drivers of performance for active portfolios.1 Despite the increasing focus on factor-based portfolios, many question whether factor portfolios generate alpha.
Factor portfolio return can be characterized as “structural return.” A quick search on the term returns few items apart from an early mention of “structural beta” by Ray Dalio of Bridgewater Associates. He did not offer a definition. This post presents a framework that decomposes the structural return into “structural beta” and “structural alpha” by applying the Capital Market Line (“CML”) methodology to select industry factor portfolios from the Kenneth French data library.
The CML represents all efficient portfolios comprised of a risk-free asset and the market portfolio. The portfolios are presented in terms of risk and return. This post uses realized return instead of the commonly used expected return.2 When the factor portfolio plots above the CML, the distance between the factor portfolio and the CML is “structural alpha.” This alpha is attributable to the factor portfolio, not the skill of the manager. When the factor portfolio plots below the CML and above the risk-free asset return, the return is attributable to “structural beta” and could have been replicated with some combination of the risk-free asset and the market portfolio. When the factor portfolio plots below the risk-free return, the portfolio return is a combination of the risky assets available for investment.3
The examples below highlight the structural return opportunities in factor portfolios targeting Energy, Food, Healthcare, and Technology.4 Food and Healthcare plot above the CML indicating structural alpha.
Focusing on a shorter period, from the Global Financial Crisis to the present, Food and Healthcare have offered structural alpha.[5]
Focusing below the line, Technology and Energy returns are attributable to structural beta. The Technology portfolio plots below the CML and above the risk-free rate. It is worth noting that substituting the broad market portfolio with the S&P 500 reduces the slope of the CML; in that case, the Technology return generates a small structural alpha. Many would agree that the S&P 500 index is easier to implement than the broad market portfolio as defined by Fama/French, but the implementation consideration is beyond the scope of this post.
[1] “Numerous studies … postulated that security prices are determined by a global equity market factor, coun- try-specific factors, global and/or local industry factors, and common company characteristics (for instance, size, success, and value). “ The Increasing Importance of Industry Factors, S. Cavaglia, et al. (2000)
[2] This analysis acknowledges the typical criticisms of the CML – varying transaction costs, lack of market efficiency, irrational/risky investors, alternative forms of risk measurement matter, and the lack of a real risk-free rate. Regardless, this is a framework for organizing thoughts on the subject.
[3] All CRSP firms incorporated in the U.S. and listed on the NYSE, AMEX, or NASDAQ.
[4] The portfolios are long-only. The industry definitions are derived from the group of 17 industry defintions. Food is Group 1. Energy combines Groups 3 and 6. Technology is Group 11. Healthcare is Group 7.
[5] While there are time periods (e.g., period of high inflation) when this is not the case, for the most part, the Food and Healthcare factor portfolios demonstrate structural alpha.