Risk Factors as Building Blocks Risk Factors as Building Blocks for Portfolio Diversification: The Chemistry of Asset Allocation Source Authors: Eugene L. Pokdaminer Video By: Zak Fischer, FSA, CERA Risk Factors as Building Blocks The Infinite Actuary 1 / 34
Overview Asset classes can be broken down into building blocks (factors) that explain the majority of assets risk and return characteristics Seemingly diverse asset classes can have unexpectedly high correlations, especially in light of the recent 2008 financial crisis Ideally, asset classes should be as independent as possible, and cover the investment universe with minimal gaps Risk Factors as Building Blocks The Infinite Actuary 2 / 34
Traditional MVO vs Risk Factors Summary Method Risk Unit Examples Traditional MVO Asset Classes Equity, bond, etc. Risk Factors Factors Inflation, GDP growth, etc. Risk Factors as Building Blocks The Infinite Actuary 3 / 34
Modern Portfolio Theory (MPT) - Basics Inputs: E(r), expected return E(σ), expected standard deviation E(ρ), expected correlations between assets One of the main insights of the model is that there are diversification benefits if correlations are less than one Portfolios are described as efficient if they provide the greatest expected return for a given level of expected risk These approaches rely heavily on inputs Risk Factors as Building Blocks The Infinite Actuary 4 / 34
Modern Portfolio Theory (MPT) - Equations CAPM: E(r a ) = r f + β a (E(r m ) r f ) = r f + β a RP APT is simply a multi-factor extension of CAPM: n E(r j ) = r f + b jk }{{} k=1 Weight of Factor k RP k }{{} Risk Premium on Risk Factor k Risk Factors as Building Blocks The Infinite Actuary 5 / 34
Mean-Variance Efficient Frontier Efficient frontier - curve composed of mean-variance efficient portfolios Risk Factors as Building Blocks The Infinite Actuary 6 / 34
Risk Factors Traditional Mean-Variance Optimization (MVO) has its shortcomings Factors The basic building blocks of asset classes and a common source of risk exposure across asset classes The smallest systematic (or nonidiosyncratic) units that influence investment return and risk characteristics Chemistry Example: Asset classes are molecules Factors are atoms Risk Factors as Building Blocks The Infinite Actuary 7 / 34
List of Common Risk Factors Capital Structure Commodities Convexity Credit Spreads / High-Yield Spread Currency Default Duration Economic Growth / GDP Growth / Developed Economic Growth Emerging Markets Inflation Leverage Liquidity Private Markets Productivity Real Estate Manager Skill Momentum Size Sovereign Exposure Real Interest Rates Value Volatility Risk Factors as Building Blocks The Infinite Actuary 8 / 34
Sample Factors Risk Factors as Building Blocks The Infinite Actuary 9 / 34
Cash through the Lens of Risk Factors Cash can be seen as a combination of the following building blocks: Real interest rates Inflation Risk Factors as Building Blocks The Infinite Actuary 10 / 34
Working with Factors Investing directly into a factor is often difficult Gaining exposure to GDP growth directly is challenging Often a long/short approach is used to gain exposure to a risk factor Some investment policies may prohibit shorting Risk Factors as Building Blocks The Infinite Actuary 11 / 34
Factor Exposure Examples Inflation - long a nominal Treasuries index, short a TIPS index Real interest rates - long a TIPS index Volatility - long the VIX futures index, TVIX, etc. Value - long a developed country equity value index, short a developed country growth index Size - long a developed country equity small-cap index, short a developed country equity large-cap index Credit spread - long a US high-quality credit index, short a T-bill/bond/note Duration - long a T-bond (long-term), short a T-bill (short-term) Developed Economic Growth - long the MSCI World Index Risk Factors as Building Blocks The Infinite Actuary 12 / 34
Exhibit 8 Risk Factors as Building Blocks The Infinite Actuary 13 / 34
Exhibit 9 Risk Factors as Building Blocks The Infinite Actuary 14 / 34
Parameter Estimation One of the biggest challenges in asset allocation is to forecast expected returns Forecasting expected returns of factors is usually even more difficult than forecasting expected returns of asset classes because the data for factors may be difficult to obtain and interpret Ex-ante estimation Based on forecasts rather than actual results Prospective Ex-post estimation Example: Creating a matrix of expected returns based on historical data Retrospective Risk Factors as Building Blocks The Infinite Actuary 15 / 34
Drill Problem #1 You talk to a fellow actuary who makes the following statement: Buying a lottery ticket is a dumb idea. It is a transaction that has negative expected value, and since most investors are risk averse it is not a smart thing to do. Analyze the above statement using the language ex-ante and ex-post. Risk Factors as Building Blocks The Infinite Actuary 16 / 34
Drill Problem #1 - Solution Buying a lottery ticket loses you money ex ante in expectation, but if you win, it was the right decision ex post. Note: The time period and information available are important considerations with the terms ex-ante and ex-post. Risk Factors as Building Blocks The Infinite Actuary 17 / 34
Exhibit 10 Risk Factors as Building Blocks The Infinite Actuary 18 / 34
Drill Problem #2 You work as a consultant and your client is looking for an asset that relatively outperforms in a low growth/high inflation macroeconomic scenario. Provide a few examples of these kinds of assets. Risk Factors as Building Blocks The Infinite Actuary 19 / 34
Drill Problem #2 - Solution TIPS Commodities Infrastructure Risk Factors as Building Blocks The Infinite Actuary 20 / 34
Exhibit 11 1 Capital Accumulation Description: Growth assets, relatively high long-term returns Examples: Global public equity, private equity, equity-like instruments 2 Absolute Return Description: Strategies intended to benefit from skillful active management, earn returns between stocks and bonds while attempting to protect capital Examples: Absolute return hedge funds, other absolute return investments 3 Flight to Quality Description: Low-risk assets, protect capital in time of market uncertainty Examples: Cash, cash equivalents, U.S. fixed income, investment grade bonds, government obligations 4 Inflation Linked Description: Real assets that support purchasing power Examples: Real estate, real assets, TIPS Risk Factors as Building Blocks The Infinite Actuary 21 / 34
Exhibit 13 Risk Factors as Building Blocks The Infinite Actuary 22 / 34
Exhibit 14 Risk Factors as Building Blocks The Infinite Actuary 23 / 34
Advantages of Factor-Based Portfolio Construction Illuminates sources of risk Enhances the way of monitoring exposures Attributes risk on the level of asset classes and the level of individual strategies Provide a useful way to group traditional classes into macroeconomic buckets Simple insights, such as the relationship between equity and credit, are reinforced by analyzing factors More complex interactions can be expressed with greater clarity through the lens of risk factors Can shed new light on the multifaceted relationships between active strategies Informs manager structure analysis Factors can, theoretically, be remixed into portfolios that are better diversified and more efficient than traditional methods Risk Factors as Building Blocks The Infinite Actuary 24 / 34
Disadv. of Factor-Based Portfolio Construction The process of identifying a set of significant/appropriate factors is subjective and can be challenging The mapping process from factors to investable instruments can be cumbersome Active, frequent rebalancing Difficult to quantify expected return parameters Use of derivatives/short positions Transaction costs (and other practical details) introduce technical difficulties for the factor-based approach Risk Factors as Building Blocks The Infinite Actuary 25 / 34
Conclusion Complete implementation and reliance on a risk factor strategy is too practically challenging for most investors However, a high-level analysis looking at factors can provide new intuition and insight The application of risk factors is still relatively new, and there are disadvantages and areas that need further research and investigation Risk Factors as Building Blocks The Infinite Actuary 26 / 34
Drill Problem #3 What are the advantages of factor-based portfolio construction? Risk Factors as Building Blocks The Infinite Actuary 27 / 34
Drill Problem #3 - Solution Illuminates sources of risk Enhances the way of monitoring exposures Attributes risk on the level of asset classes and the level of individual strategies Provide a useful way to group traditional classes into macroeconomic buckets Simple insights, such as the relationship between equity and credit, are reinforced by analyzing factors More complex interactions can be expressed with greater clarity through the lens of risk factors Can shed new light on the multifaceted relationships between active strategies Informs manager structure analysis Factors can, theoretically, be remixed into portfolios that are better diversified and more efficient than traditional methods Risk Factors as Building Blocks The Infinite Actuary 28 / 34
Drill Problem #4 What are the disadvantages of factor-based portfolio construction? Risk Factors as Building Blocks The Infinite Actuary 29 / 34
Drill Problem #4 - Solution The process of identifying a set of significant/appropriate factors is subjective and can be challenging The mapping process from factors to investable instruments can be cumbersome Active, frequent rebalancing Difficult to quantify expected return parameters Use of derivatives/short positions Transaction costs (and other practical details) introduce technical difficulties for the factor-based approach Risk Factors as Building Blocks The Infinite Actuary 30 / 34
Drill Problem #5 Describe a way to get exposure to the volatility risk factor. Risk Factors as Building Blocks The Infinite Actuary 31 / 34
Drill Problem #5 - Solution Long the VIX futures index Risk Factors as Building Blocks The Infinite Actuary 32 / 34
Drill Problem #6 Suppose that markets dive after bad news. If a flight to quality is observed, give examples of assets that may relatively outperform. Risk Factors as Building Blocks The Infinite Actuary 33 / 34
Drill Problem #6 - Solution Some examples are: Cash, cash equivalents, U.S. fixed income, investment grade bonds, government obligations Risk Factors as Building Blocks The Infinite Actuary 34 / 34