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#Investments — 20.09.2016

Factor Investing... Or When Asset Allocation Becomes Alchemy!

Sophie de La Chapelle

Asset allocation is often compared to culinary art because it requires a skilful dose of ingredients that go well together. If we take the analogy slightly further, "factor investing", a fast-growing technique of asset allocation, would correspond to molecular cuisine.  Let's take a look.

An asset class is sensitive to underlying factors, such as:

  • macro-economic (GDP growth, productivity, real interest rates, inflation, volatility);
  • regional (sovereign/currency/emerging markets risk);
  • rate-related (duration, convexity, credit spread, default risk, capital structure, etc.);
  • or even micro-economic, also known as "smart beta" (company size, value, momentum, quality, dividend yield).

When we invest in such-and-such an asset, we invest in these underlying factors and we believe that they are capable of generating long-term performance.

These factors (especially macro-economic) may be common to several asset classes that explains the strong correlation between certain asset classes. For example, the "high yield corporate bonds" and "equities" asset classes are exposed to the same factors: "currency", "volatility" and "inflation"; and are therefore closely correlated.

As such, some portfolios seem highly diversified — because they contain many different asset classes — but in reality they show strong levels of correlation. This strong correlation, particularly observed since the 2008-2009 crisis, calls into question traditional models of diversification, which are based on the assumption of uncorrelated asset classes. They justify the growing investor interest in "multi-factor" portfolios, which seek a diversification of these base factors, and no longer a diversification of assets. When these factors are taken into account for the purposes of asset diversification, risk management is improved.

However, constructing an optimised allocation based on these very specific factors may appear difficult or complex because there are few investment solutions that can isolate them separately.

Hence, given the difficulty of finding investment solutions that correspond to each of these factors, the other option is to build a portfolio of traditional and/or alternative asset classes, via what is known today as "factor investing".   

Therefore, based on one's convictions about sources of performance, we will gather growth-sensitive assets (equities, private equity, etc.) for an exposure to GDP growth, bond assets for an exposure to interest rate cuts, "real" assets (real estate, treasury inflation protected securities-TIPs) for an exposure to inflation, and so on and so forth.

And at that stage, as in culinary art, it is no longer enough to be a good chef by aptly combining different quality "ingredients", but it is equally important to be capable of understanding and anticipating the specific chemical reactions between these "ingredients" in order to create the best possible result. This is precisely the aim of factor investing! We progress from being simply an allocator to an alchemist in search of the philosopher's stone, in other words the optimal portfolio!

• Risk factors that are common to two asset classes