The benefits of diversification are well known. Investing in a number of securities allows investors to spread the risk and, if correlations (a measure of how closely the securities move in tandem) are not high, can eliminate firm specific risk. In so doing, investors can improve risk adjusted returns in their portfolios. Modern diversification began with investors spreading their assets among a number of securities, like stocks and bonds. Then, diversification evolved into placing assets in different asset classes, such as international stocks, international bonds, emerging market stocks, etc., just to name a few.
Unfortunately, simply investing in different asset classes may not get investors the desired results. Many investors think they broaden their stock diversification by adding foreign equities, and back in the 1970s, when correlations between domestic and foreign stocks ranged in the .40s (a perfect correlation is 1), they were right. Domestic stocks and international stocks moved differently much of the time. However, now the correlation between domestic and foreign stocks is closer to .90, which means the diversification benefits are mostly lost. One could argue that domestic and foreign stocks should no longer be considered separate asset classes. The bottom line is that correlations change and determining diversification based on traditional standards for asset classes may not achieve the objective.
As a result, diversifying by risk factors may be a better alternative. Risk factor exposure has gained prominence since the financial crisis of 2007. Risk factors are merely the risk exposures that drive the returns of securities and asset classes. A simple example illustrating the basic risk factors intrinsic in a stock are: 1) the movement of the overall stock market and 2) the risk specific to that company. Likewise, a bond’s return can be broken down into factors such as interest rate risk (the change in value based on interest rate movements) and credit risk (the risk of default by the issuer). In addition to these risks, some of the more common risk factors affecting returns include: inflation, liquidity, GDP, political, energy, and currency, just to name a few. In fact, Bloomberg tracks 2,000 different risk factors when breaking down security returns.
Increasing the number of risk factors in a portfolio reduces the potential of concentrating too much money in any one risk. In fact, research has shown that risk adjusted returns are improved by increasing the number of noncorrelated risk factors. In addition, through risk factor diversification, investors can get a better understanding of the shocks to which their portfolios are exposed and can reduce the risk factors they most fear.
Sadly, using a risk factor approach requires state-of-the-art software that breaks down securities and asset classes into the inherent risk exposures in each. Furthermore, optimizing portfolios based on risk factors is an added computational hurdle. Most investors lack the resources to calculate and track these factors, and therefore must rely on an investment firm that does. Regrettably, at this time there aren’t many that do.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
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