Building risk-weighted factor portfolios
FACTOR INVESTING: WHAT IT IS AND HOW TO USE IT
PART 10/10: Constructing risk-weighted factor portfolios
Client level of adoption/allocation
Since the global financial crisis investors have become more sensitive to tail risk and have renewed appreciation for diversification. As a result, risk-based portfolio construction has enjoyed more attention over the past years. To this end, investment providers globally are moving from portfolio construction approaches that prioritise prospective return premiums to approaches that use predicted risk to design a portfolio.
In this article, the final in our factor investing series, we discuss building factor portfolios using risk-based allocations. These strategies are typically designed to yield either lower portfolio volatility, or greater diversification.
Below is an illustration of risk contributions to an equally-weighted allocation, a risk parity and maximum diversification strategy.
With a naïve equally-weighted factor allocation, we immediately see how riskier factor strategies (such as value) tend to dominate factor risk contributions. This is a perhaps an obvious but important point, as investors tend to hold the illusion that the portfolio’s return experience is driven proportional to the capital allocation. On the other hand, the reality could be vastly different due to varying risk contributions from individual factors.
Risk parity aims to mitigate this problem, by solving which capital allocations provide an ‘equal risk contribution’ portfolio, or ‘risk parity’ portfolio. The result in Figure 1 is fairly intuitive, as subsequent allocations would more or less be inversely proportional to the underlying factor betas, and thus we see a meaningfully higher allocation to the low volatility factor. Risk parity strategies have also shown strong and consistent outperformance in academic literature[1] versus more traditional concentrated portfolios.
The final risk-weighted strategy is called ‘maximum diversification’. As the name suggests, this approach aims to optimise the portfolio’s diversification characteristics, which authors Choueifaty and Coignard [2008] defined as the ratio of weighted-average asset volatilities to the overall portfolio volatility. The intuition behind this construction is that each factor’s marginal contribution to risk will be equivalent for a small change in allocation, creating a perfectly diversified portfolio. Our results show that an even larger allocation to low volatility is needed (42%) to attain maximum diversification, at the expense of an allocation to quality (12%).
Thus far, empirical back-tested results of risk-weighted portfolio construction approaches using factor portfolios show promise in the South African context. Both risk parity and maximum diversification portfolios have useful properties for clients who are sensitive to risk budgeting, and appreciate balanced contributions from factors within a risk framework.
And hence we end our series on factor investing, which started with using a factor investing framework to merely understand what’s driving your portfolio’s returns, right up to the sophisticated application of factor investing to accurately bring down the risk in your portfolio. We hope you found this series useful.
[1] See Maillard S, Roncalli T and Teiletche [2010], Qian E [2011] and Clarke R, De Silva H, Thorley S [2013].
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