For many years, investors assumed that combining different asset classes within a portfolio maximized risk-adjusted returns. However, a key issue with that assumption is that other 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 the case. In contrast, examining a portfolio through a risk factor lens may allow investors better to understand overlapping sources of risk across multiple asset classes and more efficiently manage their portfolios’ overall risk exposures and expected return.

Historically, asset classes have played an essential role in the investment process. However, the typical increase in correlations during adverse markets and the mixture of underlying systematic risks make asset classes imperfect candidates for risk analysis. The higher correlations across asset classes in “bad times” suggest the existence of underlying, overlapping forces driving their risk and return dynamics. For example, overlapping exposure of equities, commodities, and credit spreads to the changes in global macroeconomic growth and investor risk aversion can drive positive correlations across these asset classes. Decomposing asset returns into fundamental risk factors that proxy for these common effects could help provide greater insight into how assets will perform under different market environments.

The Elements of Risk

For us, it is not a good enough process to diversify a portfolio by asset class because they tend to correlate in times of risk. Instead, we focus on the elements that drive the returns of different risk factors and financial markets. These elements of return drivers are the foundation of our investment philosophy. By understanding what they are and what they influence, we can build portfolios around these risk elements that offer more protection to the downside by limiting their exposure depending on their trend and the business cycle’s position.


Which Elements 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.

Factors are also cylical

Another key advantage to modeling economic factors is their tendency to follow a pattern driven by the business cycle. By classifying the different stages of the business cycle, we can estimate the changes in other factors before they change. This process does not always work, and monitoring the characteristics and business cycle is required to identify changes that are not foreseen. But the business cycle does become a roadmap to the future expectations of our economic factors and, in return, for the financial market.

We break the business cycle down into six stages. In each stage, our factors tend to act differently. As the business cycle progresses, we can anticipate the changes to the economic factors that drive returns.


For example, let’s assume that we are in the late stages of a business cycle. We can think that inflation is running high and growth is peaking. We expect growth to slow as monetary policy remains restrictive in the next business cycle phase. We know that a recession is approaching, so we can adjust our portfolio to assets sensitive to an economic slowdown, inflation, and falling yields. The result is a model that anticipates an economic downturn and recession and tactically shifts a portfolio for the shifts in the risk premium.


We have identified some of the significant factors that drive the financial markets. Also, with the use of the business cycle, we have a general idea of the direction of each of these economic factors. We can confirm that the elements are doing what we expect them to do and adjust accordingly. From there, we can tactically shift our portfolios around different factor exposure for the stage of the business cycle we are in. Together, our model provides a way not to overexpose a portfolio to risks such as a recession; while overweighting factors when they historically performed well.