Economic Factors
For many years, investors relied on the assumption that combining different asset classes within a portfolio was an effective way to maximize risk-adjusted returns. A key issue with that assumption, however, is that different asset classes may be exposed to the same systematic sources of risk, or risk factors, which may lead an investor to believe they are more diversified than is actually the case.
In contrast, examining a portfolio through a risk factor perspective may allow investors to better understand overlapping sources of risk across multiple asset classes and more efficiently manage their portfolios’ overall risk exposures and expected return.
Economic Factors
A set of macroeconomic factors explains the systemic risk that a portfolio endures and cannot be diversified away from. While non-systemic risks like a lawsuit or poor management can be diversified away through ETFs or mutual funds, systematic risks such as consumer spending and the economic growth of an economy cannot simply be diversified.
There are two methods that an investor can take to protect them from systemic risk.
Smart Beta
First, you can estimate the long-term expected return and passively invest in a portfolio that matches the investor’s tolerance toward balancing the portfolio’s exposure to certain risk factors. This method requires a long-term approach and might be hard to obtain because an investor will need to ride through the swings and changes to systemic risk that affects a portfolio—commonly known as Smart Beta investing strategies.
Smart Alpha
An alternative method comes from realizing that economic factors follow a repetitive path known as the business cycle. Understanding the business cycle and the usual way of the financial markets’ characteristics provides a roadmap that an investor can follow. This is where Alpha can be generated beyond the market’s expected to return when an investment manager correctly tilts the portfolio around the business cycle and economic factors; we call this Smart Alpha.
Elements (Factors) that Drive Returns
Like elements that makeup different materials, these are the factors that drive returns.
Like elements in the periodic table of elements, combined factors can represent different asset classes based on their exposure. For example, the equity market is sensitive to both credit and growth factors, like hydrogen and oxygen, combined to make water; the equity market risk can be explained by combining the risk factors associated with it.
Which Factors are in asset classes?
Most investors require a hearty dose of economic growth in their portfolios, which potentially can provide an attractive long-run reward associated with the growth of the global economy. We believe that there are times to focus on economic growth and other times to focus on real rates. Exposure to real rates provides an effective ballast to soften the impact of equity market drawdowns. Exposures to inflation, and credit provide four additional sources of potential return and diversification. We believe that by understanding the drivers of risk in a portfolio, we can tactically adjust the portfolio depending on the trend of the factors that make up a portfolio.
A factor-based view cuts through investment structures to focus on the underlying drivers of returns, and translates what can be often unintelligible into intuitive factor exposures. Moreover, factor investing can expose overlapping risks that could be lurking in your portfolio.
Factor Sensativity
Below is a tool we developed using our multiple regression model for identifying how particular sensitive security is to the different macroeconomic factors. Try it out to see what might be driving your investments.