By Yoram Lustig
To many investors, the concept of diversification has been synonymous with asset allocation. However, this has created portfolios often appearing well diversified by asset class, but not always across risks.
The 2008 economic crisis exposed how portfolios can be affected by changing macroeconomic events. During the crisis flight-to-quality pushed correlations among equities, corporate bonds and commodities upwards, raising questions about diversification’s validity. “Asset allocation is dead,” complained many investors, who are now re-examining their portfolios to better understand what risks they are taking.
Asset allocation strategies typically assign risk and return characteristics to asset classes and combine them to create a diversified portfolio. However, asset classes are not necessarily comprised of a single risk exposure or a single source of return. For instance, 89% of the returns from global investment grade corporate bonds have been driven by the real term premium—the risk of bearing exposure to long-term real rates—and the credit spread—the difference in yield between corporate and government bonds. Together, these two factors contributed to 92% of the asset class’ risk as measured by volatility of returns.
This is hardly surprising. However, global investment grade corporate bonds normally have a modest exposure to developed equity market and inflation risk factors. And these sources of risk can be common to many different asset classes across most fixed income and equity investments. Moreover, they change over time. For instance, in a static 50% equity 50% bond portfolio, the risk associated with developed equity markets swelled during the 2008 global financial crisis, as the exposure of investment grade credit to equity market risk ballooned, while in 2012 inflation and credit risk factors became the main sources of portfolio risk.
Asset allocation still has a place, but the analysis of risk and its sources is emerging as a new analytical tool. This allows investors to make more informed decisions about the risks they want to take or mitigate and where these may crop up. For example, when investing in certain emerging market equity markets investors are making two main investments: one in equity market risk and another in commodity risk. If the portfolio is already exposed to commodities, investors may unknowingly double up the position. Risk factor analysis, therefore, can help investors to understand their portfolio’s risk exposure and account for the dynamism of risk.
And it does not end there. Risk factor measures can be incorporated into sensitivity or scenario analysis to test how the portfolio might react to different market conditions, explain performance or assess returns relative to the risks taken. Investors might also choose to use insight from risk factor analysis to express their market views, repositioning their portfolio toward risk factors that are expected to enhance returns and away from those that are expected to detract from returns.
Risk factor analysis should not be used in isolation, as it is neither forward-looking nor does it provide insight into how markets are expected to perform or how risks should be managed. But it is a complement to traditional asset allocation and a valuable one considering the increasingly correlated and interrelated markets in which we operate in today’s globalisation. And it can help ensure investment strategy is truly diversified from both a return and a risk perspective. Long live risk factor allocation.
Yoram Lustig is UK head of multi asset investing at AXA Investment Managers and manager of the AXA IM Smart Diversified Growth fund
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