White paper

Factors for risk management

A better path to the construction and management of portfolios?

Assessing risk across a diversified portfolio can require evaluating hundreds or even thousands of bonds, stocks, and other securities — their potential for return, embedded risk, and correlations to other investments. It’s an enormously complex task, demanding access to vast amounts of continually changing data.

Factor analysis can simplify this process by identifying the key underlying drivers of risk and performance across securities, sectors, and asset classes. This approach allows us to untangle the often-complex relationships across investments that influence performance in a portfolio. Is performance tightly linked to equity market performance or economic growth? Is it affected by inflation? Is it sensitive to changes in interest rates? Factor analysis narrows the scope of risk analysis from a nearly unlimited pool of individual investments to a finite list of factors that describe their behaviour.

The factor model used to describe the risks and relationships between assets is central to risk management and portfolio construction exercises. The answers provided for these exercises rely almost exclusively on the estimates produced by the factor model.

In this paper we explore:

  • the nature of factors
  • the types of factors that are important for risk management
  • how these analytical tools may provide a more informed approach to controlling risk in diversified portfolios.
  • how they may be successfully positioned in portfolios to pursue specific return profiles

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Investment risks

  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Factor investing (as known as smart beta or active quant) is an investment strategy in which securities are chosen based on certain characteristics and attributes that may explain differences in returns. Factor investing represents an alternative and selection index based methodology that seeks to outperform a benchmark or reduce portfolio risk, both in active or passive vehicles. There can be no assurance that performance will be enhanced or risk will be reduced for strategies that seek to provide exposure to certain factors. Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. Factor investing may underperform cap-weighted benchmarks and increase portfolio risk. There is no assurance that the factors discussed will achieve their investment objectives

Important information

  • Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.