Modern portfolio theory (MPT) suggests that returns can be enhanced by reducing risk through diversification. To achieve this goal, market participants usually combine asset classes that have low correlations with one another. For example, bonds typically produce a steady stream of income, while equities can generate capital gains; the combination of equities and bonds in a portfolio can potentially provide both stability and growth features. More importantly, combining different asset classes can reduce overall volatility, which could result in a better risk/return tradeoff. The capital asset pricing model (CAPM) quantifies MPT by identifying beta, which measures a stock’s sensitivity to the market, as the single risk factor in the model. Hence, higher returns can be realized by taking on greater risk, and a more moderate return could result from taking on less risk.
Many risk factors have been identified as drivers of equity return since the introduction of CAPM. As diversification can be achieved by combining various factors that have low or negative correlation, a factor-based asset allocation approach, which is designed to capture systematic risk factor exposures, has gained popularity in recent years. Essentially, a factor-based strategy employs the underlying return drivers (factors) of securities to form a well-diversified, systematic portfolio that can deliver higher risk-adjusted returns than the broader market over a long-term investment horizon.
In this paper, we explore how a stylized, factor-based framework could be applied to equity markets in Latin America and whether performance can vary in different Latin American countries. In doing so, our research explores how a multi-factor concept, based on combining negatively correlated factors, could work effectively in a relatively volatile region such as Latin America.