A standard consideration in portfolio construction is diversification. This has traditionally been approached by investors and advisors from an asset-class perspective. The rationale is that different asset classes are generally expected to behave differently in different market scenarios. When some investments perform poorly, others should perform positively, thereby smoothing out risk and reducing exposure to portfolio-wide downturns.
However, the 2008 financial crisis was a shock for many investors as multiple asset classes experienced simultaneous downturns. Despite being diversified on an asset-class basis, many portfolios failed to adequately mitigate losses. One reason for this is that asset-class diversification does not account for risk factors.
Whereas asset classes (i.e. equities & fixed income) are groupings of securities with similar characteristics, factors (i.e. volatility, value, & size) are underlying, security-level drivers of risk and return. As investment consultant Eugene Podkaminer once remarked, “If asset classes are like complex molecules, factors are the atoms that serve as building blocks.” Instead of examining investments at an asset-class level, factor analysis provides a more granular view that helps explain drivers of performance.
As a result, portfolios diversified solely in terms of asset class may not be as safe as they appear; shared underlying risk could impact performance across various asset classes simultaneously. Take a portfolio with a 50/50 allocation between a global bond fund and a utility fund, for instance. It would contain a 50 percent investment in bonds and a 50 percent investment in equities. However, a factor analysis may reveal that the portfolio is 32 percent U.S. equity markets, 46 percent interest rate exposure, and 22 percent foreign exchange risk.
From an asset-allocation view, these factor exposures would be hidden. By considering both asset-class and factor diversification during portfolio construction, investors and advisors can better understand the risk behind their investments.