Risk factor investing: It’s not all about the upside

During the summer of 2015 and at the start of this year, we saw signs of heightened market volatility around the globe, tied to concerns about China, US monetary policy, and global growth in general. The swoon may be a harbinger of more market bumps to come. We think the traditional methods of seeking diversification to smooth out the ride need to be reconsidered, as the volatility grip tightens.

Since the financial crisis there has been a sea change in investors’ attitudes towards their portfolios. These days, it seems investors are no longer looking for portfolios that take on a lot of risk to generate a high-digit positive return. Instead, they are looking for solutions that have the potential to offer some stability of return within a certain level of risk. Increasingly, we are seeing that many investors are less concerned about whether portfolios outperform a benchmark, and are more focused on the outcome they can expect from their investments.

Multi-asset portfolios have attracted interest around the world in recent years as investors seek new ways to capture equity-like returns with less volatility. Many of these approaches have focused on traditional asset allocation methods of shifting between stocks, bonds and cash. However, we believe in using a different strategy, one based on diversifying the risk factors instead of asset classes and making use of an expanded toolkit to source uncorrelated risk factors.

The financial crisis taught us that when there is a big market shock, correlation between asset classes tends to increase, causing them to move more in sync. However, this also limits an investors’ ability to reap the full benefit of diversification.

Risk factors are the building blocks that explain the majority of an assets’ risk and return profile. Seemingly diverse asset classes may have high correlations as a result of overlapping risk factor exposures.

For instance, in a typical bond fund, there are a number of distinct risk factors: interest rate risk, credit risk and yield curve risk — e.g. the risk that the short end of the yield curve will outperform the long end. In normal markets, interest rate risk tends to dominate bond fund return, providing useful diversification from small equity-market moves. Yet in stressed markets, credit risk can dominate as the market questions the issuer’s ability to pay back the loan.

As with equities, the credit component of a bond is linked to the earnings power of the company, and when that is questioned, corporate bonds can follow equities lower. Rather than mitigating volatility, the credit risk embedded in many fixed income portfolios pushed correlations with equities higher during the financial crisis.

Instead of dampening the downturn, traditional asset classes simply reinforced each other. This is a problem today, especially in the search for yield, as many portfolios are – consciously or unconsciously — full of credit risks.

Independent and uncorrelated trades make the difference

Executing a successful investment strategy requires a combination of skill in forecasting the performance of certain asset classes and the ability to make a number of independent and uncorrelated trades or investments. We think factor analysis can improve portfolio diversification by identifying intended and unintended sources of risk. This is especially true in today’s low yield environment. A cursory glance across the investment landscape gives an indication of the extent of the challenge for traditional portfolio managers and investors. Very few assets—even those considered to be “safe assets”—are not without their challenges today.

We strive to manage our strategies within a volatility range by controlling the risk contribution of different asset classes in our portfolios. The starting point for the positioning of our portfolios is the development of broad macroeconomic, forward-looking themes which ultimately drive portfolio construction. However, the actual construction of our portfolios is fundamentally based on diversifying the risk factors, not the asset classes, and we believe that this method is the most precise means to gain exposure to our macro themes.

This means segregating and isolating individual risk factors within asset classes and finding ways to invest, or de-invest, in them separately. By doing so, we are always ensuring that one risk factor does not overly dominate the portfolio.

To that end, we categorize all of our investments into one of four styles to be more transparent about the use of the position in the portfolio and to ensure our portfolio is well diversified. Firstly, growth, or strategies that aim to find opportunities that are deemed to have good growth potential. Secondly, defensive, or strategies that aim to protect investors against significant losses from major market downturns. Thirdly, stable, or strategies that aim to offer consistently higher returns than money markets while taking on modestly higher amounts of risk. And finally, opportunistic, or strategies that are either growth or defensive that aim to capitalise on market dislocations or valuations that occur over short-term time horizons.

Certain fixed income investments should not be considered as defensive

By combining these strategies, we ensure that the portfolio is not biased in one direction. Like the aforementioned corporate bonds, even certain fixed income investments can present growth characteristics and shouldn’t be considered as defensive. By using a combination of these strategies, our aim is to better manage the downside of market developments as well as the upside.

Practically speaking, how does this impact our portfolios? Let’s take the slow-down of the Chinese economy as an example. We believe this is a true risk to watch and will likely impact various asset classes. A traditional portfolio approach might be to underweight emerging markets as many of these markets trade heavily with China. However, an alternative approach would look to generate relative value trades that take advantage of the fact that some countries will be in better positions than other.

Alternatively, we can look at more specific components of the market that we believe will be more directly impacted by the slowdown in China. In this instance, one element of the market we believe will be directly impacted by a slowing Chinese growth rate is the demand for commodities, and more specifically, copper. Chile and Brazil are both big exporters of commodities to China. While Chile exports mainly copper, Brazil’s exports are more diversified. Brazil has also been raising interest rates in an attempt to combat its inflation crisis, while Chile, in response to a fall in the price of copper, has been pushing for growth, trying to stimulate its economy even though inflation has been ticking up.

So in these two South American countries, there have been very different interest rate policies in response to the same macro shock: one raised interest rates; one lowered rates. That could give us occasion to consider some very particular trades that address the theme of slowing growth in China that are distinct and more isolated than achieved through traditional asset allocation.

That’s where we think the real value lies. We believe it’s not so much about predicting the timing of the next market turmoil, but much more about aiming for a very well-diversified portfolio that has truly uncorrelated investments which can perform in all market environments.

Matthias Hoppe, senior vice president and portfolio manager at Franklin Templeton Solutions

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