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Factor Performance across Market-Driven Scenarios

May 11, 2018
By Bob Bass, Katelyn Gallagher, Ronald Ratcliffe, PhD, Sunil Shah

Factor risk premiums have played a central role in asset pricing: in determining return premiums for benchmarking and computing costs of capital, for risk management, in constructing optimal portfolios, and in investment strategies directly focused on efficiently harvesting factor premiums across asset classes. Over the long run, factor risk premiums can exist to compensate investors for the possibility of bearing cyclical, short-term losses.

For factor investors, it is important to understand the nature of these bad times and the performance of factors during these periods. It is just as important to characterize the performance of factor returns during good times. Some of these good and bad times can be recurring, but often the economy does not cycle through exactly the same states as previous history. In these cases, how can investors estimate the behavior of factors in discrete, extreme events?

In this paper, we develop a methodology to model factor returns in scenarios which are yet to occur or do not correspond to past market conditions. We infer factor performance conditional on hypothetical market-driven scenarios. We derive regime-dependent corresponding security and asset class returns, which are functions of factors and policy drivers. The analysis is helpful in constructing robust portfolios designed for more stable performance across various scenarios, and can aid in framing and communicating portfolio risks.

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Bob Bass
Managing Director, Factor-Based Strategies Group
Robert T. Bass, Managing Director, is a member of the Factor Based Strategies Group where he focuses on the tools and analytics.
Katelyn Gallagher
Director, Factor-Based Strategies Group
Katelyn Gallagher, Director, is a senior investment strategist in BlackRock's Factor-Based Strategies Group.
Ronald Ratcliffe
Managing Director, Multi-Asset Investment Risk
Ronald Ratcliffe, PhD, is a Managing Director at BlackRock, where he is head of Multi-Asset Investment Risk - Americas West
Sunil Shah
Director, Client Insight Unit
Sunil B. Shah, Director, is head of the Client Insight Unit (CIU) which delivers portfolio analytics and insights to BlackRock's institutional clients.