Capital Ideas^™ 
Investment insights from Capital Group

I make it a point to admire the Rosetta Stone at the British Museum every time I’m in London. On a recent visit, I dragged my mildly amused family against the tide of exhausted tourists, sneaking into the gallery minutes before the museum closed for the evening. The nerd in me appreciates the historic place this polished granite boulder occupies, and at a deeper level I’m impressed by the way it helped decode a previously undecipherable language and substantially advanced scholarship. I’ve observed a similar evolution with another complex and often mysterious language: risk factors, which unlock a deeper understanding around asset classes, investments and portfolio construction.
 

• Factors can provide more intuitive relationships across categories of investments and unpack diversification and correlations more broadly than using traditional asset class and style box hierarchies.
• They clarify significant relationships within an asset class by exposing the connective tissue across investments.
• Crucially, a factor lens can support more informed tradeoffs when building portfolios, both within and among asset classes, by linking exposures across silos, for instance, between equity and high-yield debt, or between private and public equity.
• Risk factors unfold additional dimensions when analyzing ex-post risk and attribution, allowing investors additional visibility into how shocks and market events impact all parts of their portfolio.
• While this approach is not new, discussions along these lines are becoming more prevalent as more asset owners explore the Total Portfolio Approach (TPA), which is predicated on using risk factors to assemble potential investments in a coherent manner.

Fracturing asset classes into factor exposures is not a new concept; we can trace developments back more than 70 years of financial history. Extensions of the original Capital Asset Pricing Model, like Arbitrage Pricing Theory, surfaced decades ago, and the well-known Fama-French three-factor approach was proposed in 1995. But their use (and occasional abuse) has moved beyond risk systems and attribution to forward-looking portfolio construction and even as central tenets in frameworks like TPA. We briefly explore their origins, how factors influence every portfolio (yes, even yours), and what’s next.

A helpful analogy from our 2013 CFA Institute¹ article is that risk factors are the atomic building blocks of all asset classes and investments. Just as all organisms are made up of atoms, so too are U.S. equities, emerging market debt and real estate composed of exposure to macro factors like economic growth, inflation and interest rate sensitivity, alongside style factors like quality, momentum and credit spread. Factors are the basic building blocks of asset classes and a source of common risk exposures across asset classes. They are the smallest systematic (or non-idiosyncratic) units that influence investment return and risk characteristics. In this chemistry analogy, if asset classes are organisms, factors are atoms. This is how factors can help explain the internal correlation between asset classes and help uncover unexpected relationships when crossing asset class silos.

An understanding of factors can lead to a greater awareness of how investments that seem different at first glance are related and can move together in periods of market stress. A generation ago, this awareness was hidden within complex risk systems that provided historical snapshots of where the portfolio treaded. Today, they help us understand where the portfolio could be going and how it reacts to geopolitical and financial market shocks. This crossover, from ex-post to ex-ante, is one reason that factors are increasingly commonplace in conversations among investment analysts, portfolio managers, CIOs and their stakeholders.

Factors enable investors to more deeply comprehend what each component (whether an individual security, a fund or an asset class) brings to the portfolio in terms of not just expected risk and return but also the specific role it plays. The factor universe can be separated into two parts:
 

• Macro factors influence expected return and risk across all asset classes and investments
• Style factors influence expected return and risk within a specific asset class

Peeling back the labels enables a clearer understanding of how the different pieces fit together. A simple example: seemingly diverse asset classes can have unexpectedly high correlations—a result of the significant overlap in their underlying common macro risk factor exposures. For instance, private real estate is exposed to economic growth (how is the labor market faring?), inflation (are prices for goods and services rising?) and real interest rates (is financing cheap or dear?). And elsewhere in the portfolio, macro factors can also drive performance, such as in high-yield bonds. These are also exposed to economic growth (witness their correlations to equity markets), inflation and of course, real interest rates. Such complex relationships aren’t captured solely by expected return, risk and correlation terms because additional dimensions are required. These hidden relationships caused many portfolios to exhibit poor diversification in recent market downturns, and investors are using this intuition to possibly build more robust, resilient portfolios for the future.

Style factors help uncover the purpose of an investment within a narrower category and inform how it’s expected to add to the overall portfolio. When comparing strategies within, for instance, public equities or public fixed income, style factors including region, credit quality, value, momentum and spread can provide insight. Especially if a potential investment has exposure to an unexpected style. Depending on the portfolio construction approach used by an asset owner, style factors can also span across the capital structure, from stocks to bonds. Used together with macro factors, style factors contribute additional depth and resolution.

There’s no escaping the force that macro factors exert on investments. We’ve written extensively about how changes in global growth, real interest rates and inflation impact multi-asset portfolios (see Asset manager perspectives: Interview with Gene Podkaminer in the Journal of Portfolio Management). While style factors help explain returns within asset classes, macro factors are the common language for higher level asset class returns. And they are therefore the preferred language for asset allocation, both strategic and shorter term.  

The push-pull dynamic of asset owners evaluating strategies on a wide range of factor-based metrics has led to more awareness by investment teams of their portfolio’s factor exposures. And as more asset managers embrace risk factors during the portfolio construction process, there is further incentive for asset owners to use factor-based tools to craft a cohesive portfolio. For those asset owners and allocators who are slower to adopt, the hazier asset-class view may not be sufficient to spot gaps and overlaps in their portfolios. And asset managers of complex strategies may miss out on being able to demonstrate value beyond simple excess return over an arbitrary asset allocation-based benchmark. 

Gatekeepers and advisors who span the distance between external asset managers and asset owners have been early users of factors as they translate individual strategy exposures into a multi-asset, multi-manager portfolio.

In pursuit of meaningful diversification, beyond what it says on the investment label, asset owners are increasingly using a factor lens that allows them to more easily see how exposures fit together as they populate portfolios. Through painful experiences in past crises, the desire to holistically decipher investment characteristics and apply those in a forward-looking manner has motivated an intense interest in being able to place all of a portfolio’s disparate investments on the same playing field and make intelligent tradeoffs across and within, asset classes. Given their long-standing use within strategic asset allocation, accelerated by their centrality to TPA discussions, factors have been more widely adopted globally. We expect asset owners and their asset manager partners to continue becoming more fluent in this new lingua franca.