The idea in this case is that it’s the total level of fat we’re concerned about, and not so much about how we’re obtaining it.
Likewise, with funds and factor models, you might be concerned about the level of credit risk in your portfolio, and less concerned about whether this is coming from UK corporate bonds or UK equity.
Similar to the example where milk would give more calcium for the same level of fat, given valuations in the market, it may be that you could obtain a better return for the same level of credit risk by choosing equity over bonds, as an example.
Continuing the healthy lifestyle dieting analogy, a consumer would know how much fat, carbohydrates and protein ideally they would consume over the course of a day.
Similarly, within the investment factor model a fund manager can have a target group of investment factors to expose the fund to, and then select investments based on how much factor exposure they have.
By breaking down risks into these basic risk factors it is possible to model them more accurately. Unlike with asset class-based volatility models, a clearer picture is obtained of how these risks behave over time and reduce the hidden danger of a fund’s investments becoming increasingly correlated during market panics.
Factor forecasting
This may sound complicated, but funds based solely on investment factors are already available for clients to invest in.
More commonly, these factor funds are also known as ‘smart beta’. The beta referred to in the smart beta fund is actually the factor the fund aims to gain exposure to.
Another example are some multi-strategy absolute return funds which aim to provide a consistent level of return by controlling exposure to the various risk factors.
Unfortunately, as with any model, there are also some criticisms of the factor approach.
While using investment factors is a more precise framework than asset classes, there is still the problem of forecasting how a factor will behave in future and how this relates to the investment exposure that is used.
Also, while risk may be measured using factors, it is less clear if there is any corresponding return.
Indeed, it appears that being exposed to some risk factors can go entirely unrewarded. Hence, there is still some analysis required by a fund manager to choose investments that have the most upside for a given exposure to a risk factor.
