Understanding factors – the shared traits that impact risk and return across securities – is critical in helping investors manage risks and target desired investment objectives.
Factors play an important role in both risk management and investment management, but there’s a difference in how factors are defined and utilized for each activity.
Risk management factors
On a security level, good risk managers are like diligent detectives in their relentless attention to detail—examining and monitoring specific aspects of an asset’s behavior in an effort to minimize unanticipated losses in an investment portfolio. These risk management factors are the granular “clues” that can help explain the ups and downs of an asset in a wide variety of market scenarios.
There are thousands of risk management factors. Even “plain vanilla” securities such as corporate bonds can exhibit a complex web of risk factors, ranging from interest rate exposures and yield curve positioning to spread exposures and issuer-specific information.
Investment factors go the other way – zooming out to consider the intuitive and fundamental drivers that can help explain the commonalities of returns across and within asset classes. Factor investing is an investment strategy centered on understanding, and capturing those broad, persistent drivers of return that have been observed to generate long-term premiums.
The list of desirable investment factors is comparatively short. They include style factors such as value (buying underpriced assets relative to fundamentals) and size (the potential premium from smaller companies), and macro factors like inflation and the effect of economic growth on asset prices.
Both risk and investment factors play a critical role in today’s portfolio management processes. Utilized properly, they provide unique ways to manage and monitor investments.
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