Strategic Allocation to Premiums in the Equity Market

Abstract

Investors tend to focus on harvesting the risk premiums offered by traditional asset classes when making their strategic investment decisions. Some recent papers, however, argue that investors should also consider various other premiums for possible inclusion in the strategic asset allocation. Examples of such premiums that have been documented for the equity market are the size, value, momentum and low-volatility effects. In this article, the author demonstrates that the theoretically optimal strategic allocation to these premiums is sizable, even when using highly conservative assumptions regarding their future expected magnitudes. The pros and cons of two ways of obtaining the implied exposures in practice, specifically passively managed index funds versus actively managed quant funds, are also discussed.

TOPICS: Passive strategies, mutual funds/passive investing/indexing, analysis of individual factors/risk premia