The growing focus on risk factors - this new school is here to stay

"Diversification across assets does not necessarily imply diversification across risk factors and it is risk factor diversification that determines return outcomes, especially during systemic risk events,” says Andrew Weisman, CIO of Janus Capital Management’s liquid alternatives funds.

Weisman capsulizes the "new school" of diversification which focuses on risk factors and not asset classes. The old school just looked at correlations across returns and not at the drivers of those returns. When the drivers became similar like at turning point in the business cycles, assets become correlated. When inflation shocks occur, returns correlate. The new school says that you need to know the drivers or risk factors because these are what will cause correlation changes. 

Of course, the problem with the new school is that we still may not have a good understanding of how to forecast these risk factors or even measure some of these risk factors. What is the right inflation measure for an inflation risk factor? what is the right growth measure for a business cycle risk factor? 

We could say that global macro investing is fundamentally about the identification and forecasting of risk factors. If you get these risk factors right, you will be able to tilt asset allocations to your advantage relative to those who just diversify on historical. Unfortunately the movement to the new school has the some of the same problems as with the old school diversification. It is hard to measure the sensitivity to risk factors just as it is hard to measure changes in correlation. 

When there is a transition schools of thinking, the measurement and process for implementing the new view will be messy. The shift will be especially messy when global markets are in upheaval, but this process toward the use of risk factors will continue.