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“Risk-based investing” generally views a portfolio as a collection of return-generating processes or risk factors.
HML is a portfolio that goes long stocks with high book-to-market values and short stocks with low book-to-market values ; UMD goes long stocks with high returns over the past 12 months (skipping the most recent month) and short stocks with low returns over the same period; SMB goes long small-market-cap stocks and short large-market-cap stocks.
AQR is a global investment management firm that employs a systematic, research-driven approach to manage alternative and traditional strategies.
In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Discounting factors may be applied to reduce suspected anomalies. This backtest’s return, for this period, may vary depending on the date it is run. Hypothetical performance results are presented for illustrative purposes only.
Regression analysis can be done on any type of portfolio, using one factor or many. Ideally, the factors used should be similar to those present in the portfolio, or at least one should account for those differences in assessing the results (we will come back to this). The regression framework for risk factor decomposition is shown in Exhibit 1. ...
There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully con- sider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital. © AQR Capital Management, LLC. All rights reserved.
However, measuring exposures to risk factors can be a challenge. Investors need to under- stand how factors are constructed and implemented in their portfolios.
The Morningstar Global Risk Model provides a powerful new tool by allowing Morningstar Direct℠ users to make comparisons across portfolios and benchmarks on a standardized, objective basis. Users can create custom market scenarios, perform what-if analysis on market movements, and gauge their portfolio exposures to as many as 36 distinct factors.
The Global Risk Model uses the Valuation factor to evaluate how cheap or expensive an overall portfolio is compared with Morningstar’s Quantitative Fair Value Estimate (which is based on the dollar amount we believe a company is worth today).
By understanding this data and its implications, financial advisors can help educate clients about their risk exposure and help empower them to make strategic decisions about their portfolios.
The Size factor measures the market capitalization of stocks in a fund’s portfolio to identify where they fall in the market-cap ladder. Take Oppenheimer Global Opportunities ( OPGIX ), for example, which has historically had a significant exposure to the small-cap factor relative to its U.S. Fund World Small/Mid Stock Category.
The preponderance of blue bars in positive territory shows that this portfolio has been, for the most part, historically cheaper than the market.
Researching funds requires an understanding of management’s resources, experience, financial incentives, strategy, and long-term track record, in addition to costs and the strengths of the investment organization —therefore, it serves as a key way that financial advisors can help increase their value to clients.
Vanguard Dividend Growth ( VDIGX) has historically been focused on finding companies with sustainable business models and high barriers to entry that can enable them to keep growing their dividends.