Risk Factors, 10 Years On

It’s hard to believe (for me, anyway) that my first paper on risk factors, “Risk Factors as Building Blocks for Portfolio Diversification: The Chemistry of Asset Allocation” was published by the CFA Institute 10 years ago. What’s changed in how we work with factors? A lot, and not much at all.

Why factors (still) matter

Risk factors, whether macroeconomic factors which cut across all asset classes, or asset class specific factors, enhance our understanding of portfolio volatility and performance, help us construct robust and resilient portfolios, and clarify the role of each of our investments. I’ve observed plenty of innovation around this last point, especially as alternative assets increasingly make up a greater proportion of portfolio assets and risk contribution. The ability to clearly consider what drives the risk and return profile for a private investment or complex long/short strategy is becoming table-stakes in today’s world of risk systems.

Sample Asset Groupings

Where we’re stuck

But DINO (Diversification In Name Only ??) still runs rampant through many portfolios. Ostensibly well-diversified mixes containing many interesting-sounding strategy titles can still be highly correlated due to their reliance on a handful of macro risk factors which drive performance and volatility. This was true during the GFC, and in the immediate aftermath, and is still largely the case today.

Sample Portfolio Allocation

DINO is compounded by the prevalence of ever more alternatives, sometimes marketed as a diversification panacea, but featuring meaningful economic first-principal relationships with traditional asset classes.

If you don’t…someone else will

One of the more striking observations I’ve picked up from my experience in investment consulting, and leading a manager selection team for a large asset manager, is that even if your portfolio managers aren’t looking at their funds through a risk factor lens, your clients, gatekeepers, and other stakeholders certainly are. If your investment process doesn’t rely on factor-based portfolio construction you don’t get a “pass” which allows you to ignore factor attribution.

You can count on increasingly sophisticated clients and consultants using granular tools to tease out your exposures, and use those metrics to build well-behaved fund-of-fund portfolios. Surprisingly, this is lost on many asset managers - much to their detriment.

What comes next

Over the past decade I’ve observed three scalable trends which lend themselves to systematic approaches: 1) sustainability; 2) tax optimization; and 3) direct indexing. Each is predicated on quantitative scoring, and all can be used to construct bespoke optimized portfolios for individuals or institutions. Using a risk factor foundation with these trends is a natural combination.

Another area mentioned in my decade-old paper that’s still evolving is the use of risk factors on both sides of the balance sheet when considering asset-liability management and LDI solutions. With better and easier-to-use quantitative tools now available, precisely dialing-in intentional exposures to duration (both real and inflation) and credit is far more achievable now than in the past. And this translates equally to wealth management and pension de-risking.

Agree? Disagree? Want to geek out about factors? Drop me a line.