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Drilling Down for Diversification

Diagnostics help investors see beyond the asset-class level through a factor lens, and identify unintended risk

Editor’s note: This is the first of two stories on achieving truer diversification by using analytical diagnostics and factors, and implementing the resultant strategies.

Asset owners and their managers are always striving for a portfolio that, on the whole, is greater than the sum of its parts. That’s a driving force behind the quest for diversification – a portfolio, viewed holistically, that has less risk than its individual components. Often, conversations about diversification begin and end at the asset class level. Today’s investors, however, have the opportunity to create a clearer, truer picture of diversification.

Asset-class level diversification remains important and cannot be ignored; however, diversifying across common attributes of securities within each asset class is now possible, due in part to factor-based analytics. “Today we have a much more robust set of factors available that are investible, both on the equities and fixed-income side – think long-only, long-short, commodities, and alternative asset classes, for example,” says Jacob Borbidge, Portfolio Manager at Invesco. “With a broader set of tools that can be implemented into portfolios, we can think about diversification at a deeper level and add the lens of factor diversification to the overall portfolio construction equation.”

When factors are employed, an investor can assess a portfolio for value (to pick a factor) across the entire asset allocation, opening up new avenues that can reduce the correlation of strategies within the portfolio even further. “That’s really the end goal of diversification – to drive down the average correlation within your portfolio by selecting investments that behave less like other investments in the portfolio. As long as you continue to include assets with lower correlation to existing investments, you’re going to increase diversification,” says Borbidge.

Using the diagnostics toolbox

Think for a moment about two fixed-income assets: long Treasuries and high yield, for example. From a historical return perspective, long Treasuries may appear to be similar in risk to high-yield. Through a factor lens, however, diagnostic capabilities utilized by Invesco’s solutions team can disassemble these two assets based on Treasuries’ exposure to rates, revealing that high yield has exposures to rates and credit.  

“We have developed tools which allow us to drill into a portfolio and give us a complete view of the various exposures a portfolio might have from a factor perspective,” says Nicholas Savoulides, Head of Global Solutions Research at Invesco.  

Another reason why it’s important to drill into the various building blocks of a portfolio via factors is that asset classes and benchmarks are, in a manner of speaking, living things – they change. “From an asset class perspective, what we’re really looking at is the risks of a specific third-party benchmark,” says Savoulides. “But the composition of that benchmark can evolve through time. As an example, the number of BBB-rated bonds has increased significantly over the past decade or two. If you’re looking at historical behavior of a particular index in that context, you’re going to capture the behavior of something that is quite different to what you have today.” In contrast, continues Savoulides, “the factor decomposition provides a snapshot of the exposures based on today’s benchmark holdings. It’s like looking through the windshield, rather than into the rearview mirror.”

Investors’ goals are the starting point

One way of thinking about achieving diversification by using factors and related diagnostics is to compare asset allocation to complex surgery. The first thing a surgeon takes into consideration before planning the procedure is a simple question: What is the desired outcome? The thought process of the solutions team at Invesco starts from a similar position. Investors typically have clear goals, and once those are identified “factors are the foundation upon which we start building the most appropriate solution to best achieve the metrics that the client is trying to maximize,” says Savoulides. “Maybe the goal is to reduce the funding ratio volatility. In that case, as we’re calculating the risks and trying to see how we’ll best achieve the desired outcomes, we use the appropriate tools and analytics to perform the diagnostic. To the investor, factors sit behind the scene in this process, but they allow us to be more precise in our calculations, and to propose a solution that is much closer to where the client wants to be than if we stopped at the asset-class level.”

Clearly understanding client goals is a complex process. Before Savoulides and Borbidge dive into a client challenge, a thorough information-gathering process takes place. The goal is to achieve a holistic understanding of a client’s state of play, the level of resources, allocation strategies they are currently using and how they were derived, benchmarks, and board approval criteria. All of this helps the Invesco team understand risks in a common framework, and, in turn, factors help identify the drivers of those risks in terms that are relatable to clients.

“Factors provide additional color in terms of expectations,” says Borbidge. “Let’s say an asset owner has an equity-heavy portfolio and believes they are positioned to do well in a strong equity market. Factor analysis may show they are heavy from a defensive factor-exposure standpoint ­– so, in fact, if equities win, they may actually lose. With the additional factor lens to assess their portfolio we can say, ‘Here's what you expect to happen and here’s what our analytics show – are those two things aligned?’ If not, that sparks the discussion of how we can help them create alignment.”

Helpful resource: Basic concepts for understanding factor investing.

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The second part of this story, on implementing factor strategies, will appear on institutionalinvestor.com on December 3.


Disclosures:

Asset allocation, diversification and low or negative correlation do not guarantee a profit or eliminate the risk of loss. 

Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes that may explain differences in returns. There can be no assurance that performance will be enhanced or risk will be reduced for funds 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.

All content provided by Invesco is for informational purposes only and is not an offer to buy or sell any financial instruments. Invesco Advisers Inc. is an investment adviser; it provides investment advisory services to individual and institutional clients and does not sell securities. This material is for Institutional Investor Use Only. The opinions expressed in this article are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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