Understanding Investing

The Benefits of Risk Factor Investing

Steve Sapra, senior member of the client solutions and analytics team, explains how a focus on risk factors can simplify investors’ ability to assess the risk/return profile across asset classes and sectors.

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Justin: Steve, you mentioned our risk factor approach to investing. Can you elaborate on what you mean by that?

Steve: Sure. Well, think about the, uh, think about the fixed income space and the number of indices that are in the fixed income space. You have. You have treasury indices. You have corporate bond indices. You have high-yield indices. You have indices that focus more on mortgages. You obviously have domestic. You have global, uh, global indices.

But what's really key is that all of these different indices are only exposed to a handful of what we call risk factors — in other words, the primary drivers of risk and return. For example, uh, all of the benchmarks that I just mentioned have exposure in varying degrees to the duration risk factor. So, there's a common element that permeates across the entire, entire space.

Now, in terms of forming expected returns, think if one were to try and come up with expected returns for all the different types of bond indices in the universe. How, likely do you think it would be that there would be a consistency in the underlying factor views associated with that? It would essentially be zero. There's almost no chance.

But think about if you started at the risk factor level, like we do at PIMCO, if you start at the ground up by forming views on duration and credit and mortgage and so on and so forth, and then roll that up to the asset class level. What that does is it virtually ensures consistency across the entire fixed income space.

So, and this is because there's a one-to-one translation between risk factors and asset classes. It doesn't go the other way. It goes from risk factors to asset classes, not from asset classes to risk factors. So, one must start at the risk factor level to ensure that asset class views are, are consistent.

Justin: And that's helpful on the return side, but another use for risk factors is to build a lot more intuition on the risk side as well. You could look at, you know, simple asset class volatilities and simple asset class correlations. Uh, but you mentioned a few risk factors there, things like duration and, you know, equity beta or equity risk. Maybe using those as an example, can you, uh, elaborate a bit on how we use risk factors on the risk side of the equation?

Steve: Sure. Well, one of the, one of the most important considerations in portfolio construction is this relationship between the duration factor, which is effectively exposure to high quality sovereign bonds, typically US government bonds, and how the returns to that risk factor relate to things like credit and equity and so on and so forth. And over the past 20 plus years, it's primarily been the case that that correlation has been quite negative.

What that means in general, uh, is that when equity markets sell off or when, when there's an adverse movement in the credit market, exposure to high-quality duration has sort of been there as a hedge, to some degree. Not always, but largely it's been there as a hedge to offset some of that risk.

And the implication of that, then, is that balancing duration and credit or duration and equity in, say, an asset allocation portfolio, can significantly improve the portfolio's efficiency. But how do you do that, right? It's not easy. The types of things that I'm talking about are actually fairly involved and require a reasonably high degree of, of complexity and sophistication and that's why you really need a well-developed portfolio construction process in order to sort of measure these trade-offs.

Recorded 15 September 2018


All investments contain risk and may lose value. Investors should consult their investment professional prior to making an investment decision. 

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. 


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