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Factor Perspectives

Investment vs. risk management factors

Andrew Ang |Apr 6, 2018

Investment factors show the big picture — drivers of portfolio returns. Now zoom in on risk management factors to see what drives individual assets.

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 used for each activity.

Investment factors

Investment factors are the big picture — zoomed out to consider the intuitive and fundamental drivers that can help explain the commonalities of returns across and within asset classes. Investment factors are broad, persistent drivers of return that have historically earned long-term premiums.

There are two main types of investment factors: macroeconomic factors, which explain returns across asset classes, and style factors, which explain returns within an asset class.

Risk management factors

Risk management factors, on the other hand, tend to be narrow and are specialized to subsets or groups of securities. They zoom in on the tiniest 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 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.

Factor investing vs factors in risk management

How risk management factors
zoom in

Risk management factors measure specialized, idiosyncratic risks. If a corporate bond has exposure to U.S. media cable investment grade spread risk, that risk measures one particular segment of the credit market, but doesn’t tell us much about broader trends affecting global credit.

Many investors use risk management systems to monitor risk factors and zero in on exposures across individual securities. Complex risk factor exposures for a corporate bond can include interest rate exposures to multiple points on the yield curve; spread exposures to industry, maturity and rating buckets; issuer-specific information; volatility risk; liquidity and trading risk; and foreign exchange risk.

Risk factors may affect sectors broadly, but without long-term premiums. A shock in a given area, such as low commodity prices, is going to affect all mining firms. The defense and tobacco industries, for example, have traditionally had more stable returns than technology. But these sectors generally have not provided a return in excess of their exposure to overall market risk. Sectors are a broad driver of risk, but that risk factor has not had a long-run excess return.

Foreign exchange exposure is another example of a risk factor that has broad effects, but has historically shown no long-term premium.

Using both factors together

Both risk management and investment factors play a critical role in today’s portfolio management processes. Used properly, they provide unique ways to manage and monitor investments.

  • Risk management factors provide a detailed and granular view of the underlying sources of risk in the portfolio. They are primarily used to understand portfolio exposures and uncover potential vulnerabilities.
  • Factor investing is the process of understanding the exposures you want, and then allocating across and within asset classes to express those factor views.

Managing risk through a factor lens allows owners to help control overall risk as well as embrace the right kinds of risk — those that may be rewarded over the long run. This focus can help align portfolios with investment goals.