Exchange traded funds (ETFs) are a natural for investors to put into effect strategies that profit from value and momentum across sector indexes since ETFs are a liquid investment medium.

Investors are usually willing to take on risk only if they are compensated for it with greater expected reward. Although such theories as Ross’s (1976) arbitrage pricing theory (APT) suggest there may be multiple sources of risk, including both systematic risk factor exposures and idiosyncratic risk (Merton 1987; Malkiel and Xu 2006) that are rewarded in equity markets, both empirical financial research and practical investment strategies rely mainly on a market-wide risk factor represented by a broad portfolio of stocks.

This reliance is reflected in the dominance of country and regional indexes and exchange traded funds (ETFs) that provide exposure to marketwide equity risk for different regions. There are also, however, many other types of equity exposure that can lead to risk premiums. These exposures exploit differences in expected returns across stocks and tilt the portfolio towards stocks with higher expected returns.

Value and momentum are among the most robust return drivers in the cross section of expected equity returns. Starting with Jegadeesh and Titman (1993), the academic literature has provided ample evidence that stocks with high returns in the past yield high returns in the future.

The momentum effect is a short-term phenomenon that holds over time periods of one to four quarters of past and future returns. Another driver of cross-sectional return differences is the value effect.

Stocks with low price-earnings ratios or high dividend yields tend to outperform stocks with high price-earnings ratios or low dividend yields. This effect is well known to investment professionals who have long advocated buying cheap or distressed stocks (Graham and Dodd 1934), a recommendation whose soundness has been confirmed by many empirical studies (Fama and French 1992).

Using such strategies on individual stocks, however, may result in large trading costs, greatly reducing the return benefits to momentum or value strategy (Korajczyk and Sadka 2004; Lesmond, Schill and Zhou 2003).

An alternative is to use these strategies by sector (Grinblatt and Moskowitz 1999; O’Neal 2000; Scowcroft 2004). ETFs are a natural for putting into effect strategies that profit from value and momentum across sector indices, as they are a liquid investment medium.

Although exposure to broad market risk or to value and momentum effects is expected to yield attractive performance over the long run, particular market conditions can hurt investors who are exposed to these factors. When moving away from the market factor and trying to exploit value or momentum effects, investors’ portfolios tend to become more concentrated, increasing drawdown risk.

In recent research supported by Amundi ETF as part of the core-satellite and ETF investment research chair at Edhec-Risk Institute*, we evaluate the access to value and momentum premiums gained by using risk-controlled strategies.

In particular we use both the broad market index and value or momentum trading strategies across sectors in a dynamic core-satellite (DCS) portfolio. We assess the risk-control benefits of the DCS portfolios.

In addition to the benefits of dynamic risk budgeting, the research highlights the role of ETFs in value and momentum trading strategies that are often perceived to be strategies for individual stocks. A contribution of our research is to apply value and momentum investing to ETFs, focusing on sector-level effects.

Literature on cross-sectional effects
The value effect was first described by Graham and Dodd (1934) in their book Security Analysis. The general idea was that a security could be mispriced with respect to the value of a company’s operations and that investors should take advantage of this mispricing by buying the undervalued stocks and selling the overvalued ones.

Graham is a pioneer in the use of the price earnings ratio (PER), which became a key ratio in the analysis of the value of securities.

This basic intuition that value stocks provide higher expected returns has been confirmed in many academic studies. Basu (1983) finds there is a positive relation between average return and price-earnings ratio. Stattman (1980) and Rosenberg, Reid and Lanstein (1985) show there is a positive relation between average return and book-to-market equity. Finally, Chan, Hamao, and Lakonishok (1992) find book-to-market equity is also a powerful factor of average returns on Japanese stocks.

Building their paper on all research into the cross-section of expected returns, Fama and French (1992) show for the period from 1963 to 1990 that size of equity and book-to-market equity capture the cross-sectional variation in average stock returns. The momentum effect, on which investment professionals also rely, is depicted in the literature as a short-term phenomenon in which the past performance of assets is persistent (so-called return continuation). So, assets that have performed well in the past will continue to perform well.

Jegadeesh and Titman (1993) provide evidence that strategies that buy stocks that have performed well in the past and sell those that have performed poorly generate significant positive returns over holding periods of three to 12 months.

Value and momentum strategies may improve portfolio performance and reduce sensitivity to cyclicality (Babameto and Harris 2008). In our research we integrate value and momentum strategies through dynamic core-satellite portfolios.

To put these strategies into effect, we rely on the dynamic core-satellite portfolio framework developed by Amenc, Malaise and Martellini (2004). Amenc, Goltz and Grigoriu (2010) do further research into the use of dynamic core-satellite portfolios.

Since these portfolios offer exposure to the market, they assert that the best way to get broad and diversified exposure to market indices would be to invest in ETFs. These instruments provide transparent exposure to the market and liquidity. This liquidity is one key requirement of our strategy since it involves frequent rebalancing.

The objective of our research is to introduce a new way to exploit these effects. We have seen that the literature abounds with evidence of the benefits of both value and momentum strategies.

In practice, however, these strategies often lead to losses. When certain stocks become cheap as measured by dividend yield or PER, it may still take them time to recover, thereby exposing investors to serious drawdown.

Likewise, momentum strategies could be affected by market conditions in which past winners do worse than past losers. In general reducing the universe of stocks by excluding growth stocks or past losers will automatically lead to concentration greater than that of holding a portfolio of all stocks and is thus likely to expose investors to drawdown risk. By implementing these strategies in a dynamic core-satellite portfolio, we enable the investor to get exposure to these risk premia and protection from downside risk.

There is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek higher performances. Momentum and value are among the most robust return drivers in the cross section of expected returns.

Dynamic risk budgeting methodologies such as Dynamic Core Satellite strategies (DCS) are used to provide risk-controlled exposure to different asset classes.

We examined how to exploit the value and momentum anomalies using a DCS investment model. Our research shows the DCS approach can boost portfolio returns while keeping downside risk under control.

The implementation of the portfolio strategies is enabled by ETFs, which are natural investment vehicles since they offer a broad exposure to the markets and provide the necessary liquidity to the frequent rebalancing of the DCS model.

Felix Goltz, head of applied research, and Lin Tang, research analyst, both at Edhec-Risk Institute; and Jean-René Giraud, CEO, and Elie Charbit, head of asset allocation models, both from Koris International, wrote this article

Footnote
*Goltz, FL Tang; Giraud, J-R and Charbit, E "Capturing the Market, Value, or Momentum Premium with Downside Risk Control: Dynamic Allocation Strategies with Exchange Traded Funds," July 2011, Edhec-Risk Publication produced as part of the Amundi ETF core-satellite and ETF investment research chair at Edhec-Risk Institute.

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