Education

Understanding Risk Factor Diversification

What you will learn

Why traditional asset allocation isn’t always enough
How risk factor diversification works
The impact of risk factor diversification on a portfolio

Risk factor diversification is a strategy of spreading the underlying risk exposures driving the return of a portfolio. While traditional asset allocation strategies seek to mitigate overall portfolio volatility by combining asset classes that don’t tend to move in the same direction at the same time, seemingly distinct asset classes may behave similarly and may not adequately diversify portfolios. Understanding risk factors that many asset classes share can help create more effective portfolio risk management.

Why is risk factor diversification important in a portfolio construction?

Risk factor diversification is important as it enables investors to pursue returns while managing risks within their portfolios. Consider that even highly diversified portfolios may not adequately cushion market volatility stemming from underlying risk factors. Understanding the risk factors many asset classes share can help to create more effective portfolio risk management.

Traditional asset allocation strategies seek to mitigate overall portfolio volatility by combining asset classes with low correlations. However, long-term trends such as globalization are driving correlations higher. As a result, seemingly distinct asset classes may behave more similarly than many investors may expect. As such, even portfolios that are well diversified across asset classes may not be positioned to adequately mitigate market volatility.

The chart on the left below shows an example portfolio that is broadly diversified across asset classes. But, as the chart on the right shows, the same portfolio actually has very concentrated exposure to underlying equity risk. Understanding these risk factors is key to creating an efficient, risk-managed allocation strategy.

Endowment Style Portfolio

The figure displays two pie charts: one showing asset allocation and the other one displaying risk allocation. The pie chart for asset allocation, shown on the left, uses market value weight. It gives the percentages, in various colors on the chart, for 17 different asset classes. Private equity represents the largest share of the pie, at 17.7%, followed by hedge funds at 16.3%, developed equity, at 13.6%, domestic equity, at 13%, and venture capital, at 12.2%. Among the other dozen categories, three of them have the smallest share, at 0.5%: Treasury Inflation Protected Securities, U.S. high yield, and master limited partnerships. Cash makes up 3.5% of the pie. Moving to the right-hand pie chart, it’s clear the same portfolio actually has very concentrated exposure to underlying equity risk, with a breakdown of risk allocation by contribution to estimated volatility. World equity developed markets takes up the largest share of the chart, with a 63% risk allocation. Equity industry/style is next, at 13%. Liquidity takes up 8%, and world equity emerging market represents 5%. Other categories show slices on the chart ranging from 0% and 4%.

For Illustrative Purposes Only.

Portfolio asset allocation information is from the 2023 NACUBO-TIAA Study of Endowments. This study is based on information collected as of 30 June 2023 based on information collected from 688 U.S. based endowments. The asset allocation percentages shown are based on the average endowment portfolio as of 30 June 2023.

Risk factors explained

Risk factors are the underlying risk exposures that drive the return of an asset class. For example, the return from a share or stock can be broken down into equity market risk – movement within the broad equity market – and company-specific risk. A bond’s return may be explained by interest rate risk – price sensitivity to changes in rates – and issuer-specific risk. Currency risk is also a factor for assets denominated in foreign currencies.

By targeting exposure to these underlying risk factors, investors can select a mix of asset classes that provide more diversified portfolio risk.

Asset Class Exposure Model

For Illustrative Purposes Only.

Source: PIMCO. Spread duration refers to the price sensitivity of a specific sector or asset class to a 100-basis point (1%) movement in its spread relative to Treasuries.

The allocation model is based on Global Equities represented by MSCI All Country World (ACWI) Index. Fixed Income represented by Bloomberg U.S. Aggregate Index. Global Bonds represented by Bloomberg Global Aggregate USD-hedged Index. TIPS represented by Bloomberg Barclays U.S. TIPS Index. Private Equity represented by Cambridge Associate U.S. Private Equity. Hedge Funds represented by HFRI foF: Diversified Index. Real Estate represented by NCREIF Property Index. Commodities represented by Bloomberg Commodity TR Index. Cash represented by 3-Month USD Libor Index. It is not possible to invest directly in an unmanaged index.

Applying risk-factor-based diversification to a portfolio

Using an allocation strategy based on risk factors can help investors more effectively choose a mix of asset classes that best diversifies their risks, while also reflecting their views on the economy and financial markets.

For example, adding foreign currency exposure to a portfolio could be achieved by investing directly in currencies. Alternatively, it could be achieved by buying foreign equities, bonds or even commodities if valuations seemed more attractive among these asset classes. Over time, that flexibility can help add significant value to a portfolio. A professional investment manager using a risk-factor-based approach will take a forward-looking macroeconomic view on a wide range of variables, including monetary policy, currencies and economic growth trends.

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