Factor investing series

Constructing risk weighted factor portfolios

| 11 January 2018

Satrix factor series: “Practical applications in factor investing”

Part 10/10: Constructing risk weighted factor portfolios

Client level of adoption/allocation:

Factor investing has the ability to empower consultants, multi-managers and advisors to build client portfolios simply and efficiently.

From 1) the transparent manner in which factor portfolios are systematically constructed, to 2) the capability of building tailored investment outcomes with greater diversification and predictability, to 3) the low fees, to 4) the reliability in consistently delivering a specific investment philosophy; factor investing is beginning to revolutionise the investment industry.

While the potential impact of factor investing is transforming in nature, the level of adoption by clients varies by degree of simplicity, from ‘not allocating’ to ‘sophisticated allocation’. In this series we aim to highlight all applications of factor investing across this continuum.

This article is the final in our series of articles aimed at discussing practical ways to employ the power of factor investing. The previous article discussed building outcome orientated multi-factor portfolios.

In this article, we discuss building factor portfolios using risk-based allocations. These strategies are typically designed to yield either lower portfolio volatility, or greater diversification.

Risk-based portfolio construction has seen increasing attention over the past several years, due in particular to the post-global financial crisis where sensitivity to tail risk and appreciation for diversification had increased. To this end, investment providers globally have started to consider portfolio construction approaches which, instead of prioritising prospective return premiums, have exclusively used predicted risk as a basis of designing the portfolio.

In this article, we highlight a few of these approaches and provide some insights into applying these approaches using underlying factor portfolios as building blocks. 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 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.

For more information on this topic, or for additional details on our analysis, please feel free to contact us directly.

Watch this video

Share article:

Let us know your thoughts

Your email address will not be published.