The train track of risk poses challenges to investors as connections multiply and lines diverge, so knowing the dangers and how they are linked is central to portfolio construction.
Using the values generated by a risk factor modelling allows investors to build a portfolio that satisfies their risk/return profile. Their objective will be to get the right exposure to the risk factors they are concerned about.
They may want to minimise the effects of all but one factor. If, for example, an investor’s key skill is stockpicking, they may want to limit their exposure to that single factor.
Alternatively, they may have a strong view and want to express it. In this case it is possible to build a portfolio containing a series of assets that have a strong linkage to that risk factor.
Why do we not all look at portfolio construction and asset selection principally by reference to risk factors? Because it is hard to do well, and done badly can be misleading. It is easy to say “keep 20% in bonds”, and it is easy for trustees to check that this rule has been complied with. Saying “keep the risk factor value below 2” is harder to check. This “measurement bias” is important; it is more complex for a manager to make a proposal based on risk factors than on traditional asset allocation.
Knowing the risks and how they relate to each other should be at the heart of portfolio construction.
Charles Mackinnon is the chief investment officer of Thurleigh Investment Managers.