Our 4×4 asset allocation The philosophy approaches each asset or strategy based on the way it contributes to or detracts from 4 goals: growth, income, preservation and liquidity. Especially under the 4×4 goal parity Within this framework, each of those goals has equal weight.
So, from this attitude, what does a goals-based approach to equity aspects appear to be?
The literature on justice aspects, particularly Eugene F. Fama and Kenneth R. French’s clan of things, is deep and extensive. These include Small Minus Big (SMB) and High Minus Low (HML), which respectively describe the difference between the returns of small and huge cap stocks and high book-to-market and low book-to-market stocks.
Newer aspects include Robust Minus Weak (RMW) and Conservative Minus Aggressive (CMA), that are the difference in returns between corporations with robust and weak operating profitability and between people who invest conservatively and aggressively. The Kenneth R. French Data Library Also includes momentum (Mom), which is the return spread between winners and losers during the last 12 months, in addition to short-term and long-term reversal aspects (ST_Rev, LT_Rev).
While many researchers deal with the standalone performance metrics of every factor, we’re more concerned with the relationships between the aspects themselves, their (nonlinear) relationships with larger market and macroeconomic conditions, and ultimately the role of every consider a goal-based, investor-specific portfolio.
How do the easy correlations between aspects compare? Market Excess Return (Mkt-RF) is negatively correlated with Mom, HML and RMW, a typical indicator of quality. However, Mkt-RF correlates most negatively with CMA, which could also be a “quality of management behavior” factor and will be a top quality or defense factor. This signifies that aggressively investing executives engaged in empire constructing may do well during capital flows but suffer during market downturns. Conservative corporations, however, save money for rainy days and rely less on external financing. HML and CMA have a 68% correlation. This may very well be because investors place higher valuation metrics on corporations with fast-growing assets than their slower-growth peers. In any case, based on empirical correlations, HML can also be a defensive factor as value tends to do well in recessions.
Fama-French factor correlations, July 1963 to December 2022
Methodology: Standard Pearson correlation coefficients calculated using monthly returns.
But what does a non-linear evaluation of the aspects reveal once we compare their skewness and convexity with essential risk aspects corresponding to Mkt-RF, monthly changes in 10-year Treasury yields, monthly changes in the cash market or “risk”? -free” rates of interest (RF) and monthly changes within the CPI-U index?
Convexity reflects the coefficient of skewness between a Fama-French factor and two instances of a risk factor squared. In particular, the co-skewness of Mkt-RF with itself is solely Mkt-RF skewness. If a Fama-French factor has a positive parallel skewness to a risk factor, it’s convex with respect to that risk factor. If it has negative parallel skew, it’s concave. For example, Mkt-RF is concave with respect to CPI MoM, while CMA is convex with respect to Mkt-RF.
Fama-French Factor Skewness and Convexity, July 1963 to December 2022
Red cells represent negative and blue cells represent positive co-skewness values.
Skewness and co-skewness coefficients calculated with monthly returns and bounded by [-0.5,0.5].
Convexity relative to a key risk factor indicates higher performance in crises attributable to rapid rate of interest changes, inflation, or sharp market declines. Heuristically, convexity should contribute to our (real capital) conservation goal. Conversely, concave, negatively skewed assets and methods can behave like income-producing corporate bonds and stocks, which perform best in calm environments but underperform during crises.
Convexity and concavity: CMA vs. Mkt-RF and Mkt-RF vs. CPI MoM
In 4×4 goal parity We quantify this intuition with two investor-specific parameters: strategic horizon and loss tolerance. In particular, we take a look at the Fama-French aspects from 1963 to 2022. Taking under consideration a strategic horizon of 10 years and a loss tolerance of 15%, our methodology shows the next:
- Value (HML) contributes significantly to preservation and provides some protection during recessions.
- CMA and LT_Rev aspects are even higher preservation aspects. In particular, HML, CMA and LT_Rev performed thoroughly in 2022 as each stocks and bonds fell.
- RMW overlaps with quality and dividend stocks and contributes more to earnings.
- Twelve-month window The mother also contributes to the income. A faster mother would supply more preservation.
4×4 Asset Map: Investor Goals and Fama-French Factors, July 1963 to December 2022
Strategic horizon 𝑇=10 years, barrier “significant loss” B=85%. The eight-factor portfolio includes equal weights of Mkt-RF, SMB, HML, RMW, CMA, Mom, ST_Rev and LT_Rev.
Sources: proprietary methodology from 4x4invest; Kenneth R. French Data Library
From our goal-oriented perspective (or a macro perspective), Fama-French aspects play very different roles.
So should investors construct diversified factor portfolios that balance all of our 4×4 objectives? To begin answering this query, we built an equal-weighted portfolio of eight Fama-French aspects – Mkt-RF, SMB, HML, RMW, CMA, Mom, ST_Rev and LT_Rev – and rebalanced it monthly.
From 1963 to 2022, the eight-factor portfolio underperforms Mkt-RF in bull markets but performs significantly higher in bear markets and with lower volatility. The portfolio achieves a Sharpe ratio of 1.16 in comparison with 0.42 for Mkt-RF excluding transaction costs. Perhaps the inflated stock market returns reflect GDP growth in the massive and comparatively closed U.S. economy. From this attitude, the performance pattern of the eight-factor portfolio more closely resembles that of U.S. nominal GDP, with much lower tracking error.
Mkt-RF and eight-factor portfolio in comparison with U.S. nominal GDP growth, July 1963 to December 2022
The eight-factor portfolio includes equal weights of Mkt-RF, SMB, HML, RMW, CMA, Mom, ST_Rev and LT_Rev. 4x4invest’s calculations are for illustrative and academic purposes only. Past performance is not any indication of future results.
The 4×4 asset map above shows that the eight-factor equal weighted portfolio is fairly near a 4×4 optimal goal parity portfolio with equal weight on growth, income, preservation and liquidity. The relationships between the assorted aspects vary over the six-decade study period. Nevertheless, the implementation of all 4 objectives can have resulted within the diversification advantages vital to attain resilient performance within the bear markets of 1972 to 1974, 2000 to 2002 and 2007 to 2009, and 1969 to 2022, when each stocks and bonds dissatisfied achieve.
Factor performance in bear markets
Sources: Kenneth R. French Data Library, Bloomberg. 4x4invest’s calculations are for illustrative and academic purposes only. Past performance is not any indication of future results.
In practice, portfolios that include all major asset classes utilize aspects that go well beyond the Fama-French universe. Balanced and tailored Goal Parity Factor portfolios can provide investors with competitive returns and overall smoother performance – as they seek capital preservation in times of crisis and manage their fear of missing out (FOMO) in bull markets.
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