The new portfolio management view is that the focus of investors should be on risk-based investment decisions not asset-based decisions. Stop thinking about what is your exposure to bonds or stocks and think about your exposure to inflation or economic growth. The assets do not matter. The factor risks matter.
It is not easy to make this switch and it still requires that you map risks into asset allocation space, but this focus on factor risks is a strong advancement to money management practices. This change in focus to risk-based analysis has taken two directions. First, there has been the moment to risk-parity types of allocation decisions. Second, there has been a focus on alternative beta analysis. Both of these approaches have shown to have advantages over a portfolio management process based on fixed allocations to asset classes.
The evolution to risk parity approaches is a further advancement on diversification. If you believe that diversification is the only or true free lunch in investments, it does not make sense to hold more equities relative to fixed income. Equities are riskier than fixed income. You do not provide the maximum amount of diversification when you hold more equity risk. Asset classes could be diversified through equating their volatility or contribution to risk. There are drawbacks to this approach. Clearly, there will be a greater exposure to fixed income which has lower volatility. If equities have a higher risk premium, the equality to risk will change the exposure to significant return contributors.
The rise of alternative beta focuses on the risk factors that drive return. We know there are well-defined risk factors which can be isolated relative to overall market risk. There is a value effect, and small firm effect in equities. There is a backwardation effect in commodities. There is a term premium and credit risk premium in fixed income. There is a momentum effect in most asset classes. All of these can be used to diversify portfolio returns. This is the foundation of alternative beta strategies.
Finally, there are risk-based factors associated with macroeconomics. There is inflation and growth risks that impact asset classes differently. Equities should be less affected by inflation than fixed income. Growth will impact equities and fixed income albeit with different sensitivities. Ultimately, investors want protection from the "bad times" of slow growth and high inflation and it makes sense to directly identify a portfolio's sensitivity to those factors.
The problem with any switch to risk-based factors is twofold. The sensitivity to risk factors is not stable. Inflation sensitivities changes through time. More important is tracking error. A switch to risk-based investing will generate significant tracking error to traditional benchmarks. This creates anxiety for the portfolio managers. What works in theory may just not make a portfolio manager willing to take the career risk of tracking error. Survey work suggests that over 40% of pensions may be willing to make some switch to risk-based or alternative beta management, but this may be a slow process. This may seems like an odd impediment, but it could one of the largest. The process of education and acceptance takes time.
It is not easy to make this switch and it still requires that you map risks into asset allocation space, but this focus on factor risks is a strong advancement to money management practices. This change in focus to risk-based analysis has taken two directions. First, there has been the moment to risk-parity types of allocation decisions. Second, there has been a focus on alternative beta analysis. Both of these approaches have shown to have advantages over a portfolio management process based on fixed allocations to asset classes.
The evolution to risk parity approaches is a further advancement on diversification. If you believe that diversification is the only or true free lunch in investments, it does not make sense to hold more equities relative to fixed income. Equities are riskier than fixed income. You do not provide the maximum amount of diversification when you hold more equity risk. Asset classes could be diversified through equating their volatility or contribution to risk. There are drawbacks to this approach. Clearly, there will be a greater exposure to fixed income which has lower volatility. If equities have a higher risk premium, the equality to risk will change the exposure to significant return contributors.
The rise of alternative beta focuses on the risk factors that drive return. We know there are well-defined risk factors which can be isolated relative to overall market risk. There is a value effect, and small firm effect in equities. There is a backwardation effect in commodities. There is a term premium and credit risk premium in fixed income. There is a momentum effect in most asset classes. All of these can be used to diversify portfolio returns. This is the foundation of alternative beta strategies.
Finally, there are risk-based factors associated with macroeconomics. There is inflation and growth risks that impact asset classes differently. Equities should be less affected by inflation than fixed income. Growth will impact equities and fixed income albeit with different sensitivities. Ultimately, investors want protection from the "bad times" of slow growth and high inflation and it makes sense to directly identify a portfolio's sensitivity to those factors.
The problem with any switch to risk-based factors is twofold. The sensitivity to risk factors is not stable. Inflation sensitivities changes through time. More important is tracking error. A switch to risk-based investing will generate significant tracking error to traditional benchmarks. This creates anxiety for the portfolio managers. What works in theory may just not make a portfolio manager willing to take the career risk of tracking error. Survey work suggests that over 40% of pensions may be willing to make some switch to risk-based or alternative beta management, but this may be a slow process. This may seems like an odd impediment, but it could one of the largest. The process of education and acceptance takes time.
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