Understanding Risk Factor Diversification
Why isn’t traditional asset class diversification enough?
Traditional allocation strategies seek to mitigate overall portfolio volatility by combining asset classes with low correlations to each other, meaning that they tend not to move in the same direction at the same time. However, asset class correlations are less stable than many investors realize, and long-term trends such as globalization are driving correlations higher. In addition, correlations typically increase during periods of market turbulence. As a result, seemingly distinct asset classes are likely to behave more similarly than many people expect. In other words, even portfolios that are well diversified across asset classes may not be positioned to adequately diversify and cushion market volatility(Figure 1).
What is a risk factor?
Risk factors are the underlying risk exposures that drive the return of an asset class (see Figure 2). For example, a stock’s return 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. And currency risk is 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 provides more diversified portfolio risk.
How does risk factor-based allocation work?
While it’s not possible to invest directly in a “risk factor,”using an allocation strategy based on risk factors can help investors more effectively choose a mix of asset classes thatbest diversifies their risks while also reflecting their viewson the global economy and financial markets.How would such a strategy work? By understanding the underlying risk factors within various asset classes, investors can ultimately choose which asset class allows them to most efficiently obtain exposure to that particular risk factor. For example, if they wished to add foreign currency risk to their portfolio, they could do so by investing directly in currencies, but they could also consider foreign equities, bonds or even commodities, if valuations seemed more attractive among those asset classes. Over time, that flexibility can help add significant value to a portfolio.
How can investors apply risk factor-based diversification to their portfolios?
Using a risk factor-based approach requires a forward-looking macroeconomic view on a wide range of variables, including monetary policy, geopolitical developments, inflation, interest rates, currencies and economic growth trends. Because few individuals have the resources or infrastructure to continually monitor these factors, it may make sense for them to talk to their financial advisors about funds that use such an approach.
Disclosures
A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. Diversification does not ensure against loss.
The allocation models presented here are based on what PIMCO believes to be generally accepted investment theory. They are for illustrative purposes only and may not be appropriate for all investors. The allocation models are not based on any particularized financial situation, or need, and are not intended to be, and should not be construed as, a forecast, research, investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Individuals should consult with their own financial professionals to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments. Volatility is historical and is likely to change over time. Other fixed income allocations may be less volatile. Fixed income is only one possible portion of an investor’s portfolio, which can also include equities and other products. Investors should speak to their financial professionals regarding the investment mix that may be right for them based on their financial situation and investment objectives.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for Compliance Notes their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2024, PIMCO.
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