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Building risk-weighted factor portfolios

| Factor Investor Series

FACTOR INVESTING: WHAT IT IS AND HOW TO USE IT

PART 10/10: Constructing risk-weighted factor portfolios

Client level of adoption/allocation

Since the global financial crisis investors have become more sensitive to tail risk and have renewed appreciation for diversification. As a result, risk-based portfolio construction has enjoyed more attention over the past years. To this end, investment providers globally are moving from portfolio construction approaches that prioritise prospective return premiums to approaches that use predicted risk to design a portfolio.

In this article, the final in our factor investing series, we discuss building factor portfolios using risk-based allocations. These strategies are typically designed to yield either lower portfolio volatility, or greater diversification.

Below is an illustration of risk contributions to an equally-weighted allocation, a risk parity and maximum diversification strategy.

 

With a naïve equally-weighted factor allocation, we immediately see how riskier factor strategies (such as value) tend to dominate factor risk contributions. This is a perhaps an obvious but important point, as investors tend to hold the illusion that the portfolio’s return experience is driven proportional to the capital allocation. On the other hand, the reality could be vastly different due to varying risk contributions from individual factors.

Risk parity aims to mitigate this problem, by solving which capital allocations provide an ‘equal risk contribution’ portfolio, or ‘risk parity’ portfolio. The result in Figure 1 is fairly intuitive, as subsequent allocations would more or less be inversely proportional to the underlying factor betas, and thus we see a meaningfully higher allocation to the low volatility factor. Risk parity strategies have also shown strong and consistent outperformance in academic literature[1] versus more traditional concentrated portfolios.

The final risk-weighted strategy is called ‘maximum diversification’. As the name suggests, this approach aims to optimise the portfolio’s diversification characteristics, which authors Choueifaty and Coignard [2008] defined as the ratio of weighted-average asset volatilities to the overall portfolio volatility. The intuition behind this construction is that each factor’s marginal contribution to risk will be equivalent for a small change in allocation, creating a perfectly diversified portfolio. Our results show that an even larger allocation to low volatility is needed (42%) to attain maximum diversification, at the expense of an allocation to quality (12%).

Thus far, empirical back-tested results of risk-weighted portfolio construction approaches using factor portfolios show promise in the South African context. Both risk parity and maximum diversification portfolios have useful properties for clients who are sensitive to risk budgeting, and appreciate balanced contributions from factors within a risk framework.

And hence we end our series on factor investing, which started with using a factor investing framework to merely understand what’s driving your portfolio’s returns, right up to the sophisticated application of factor investing to accurately bring down the risk in your portfolio. We hope you found this series useful.

[1] See Maillard S, Roncalli T and Teiletche [2010], Qian E [2011] and Clarke R, De Silva H, Thorley S [2013].

Disclosure/disclaimers

Sanlam Investments consists of the following authorised Financial Services Providers: Sanlam Investment Management (Pty) Ltd (“SIM”), Sanlam Multi Manager International (Pty) Ltd (“SMMI"), Satrix Managers (RF)(Pty) Ltd, Graviton Wealth Management (Pty) Ltd (“GWM”), Graviton Financial Partners (Pty) Ltd (“GFP”), Radius Administrative Services (Pty) Ltd (“Radius”), Blue Ink Investments (Pty) Ltd (“Blue Ink”), Sanlam Capital Markets (Pty) Ltd (“SCM”), Sanlam Private Wealth (Pty) Ltd (“SPW”) and Sanlam Employee Benefits (Pty) Ltd (“SEB”), a division of Sanlam Life Insurance Limited; and has the following approved Management Companies as defined in the Collective Investment Schemes Control Act, No 45 of 2002 (“CISCA”): Sanlam Collective Investments (RF)(Pty) Ltd (“SCI”) and Satrix Managers (RF)(Pty) Ltd (“Satrix”).

Although all reasonable steps have been taken to ensure the information on this website/advertisement/brochure is accurate, the Sanlam Collective Investments (RF) (Pty) Ltd / Satrix Managers (RF)(Pty) Ltd (Sanlam Collective Investments) does not accept any responsibility for any claim, damages, loss or expense; however it arises, out of or in connection with the information. No member of Sanlam gives any representation, warranty or undertaking, nor accepts any responsibility or liability as to the accuracy of any of this information. The information to follow does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act, No 37 of 2002 (“FAIS”). Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. The Sanlam Group is a full member of the Association for Savings and Investment SA. Collective investment schemes are generally medium- to long-term investments. Please note that past performances are not necessarily an accurate determination of future performances, and that the value of investments / units / unit trusts may go down as well as up. A schedule of fees and charges and maximum commissions is available from the Manager, Sanlam Collective Investments (RF) Pty Ltd / Satrix Managers (RF) (Pty) Ltd, a registered and approved Manager in Collective Investment Schemes in Securities. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage and service fees. Actual investment performance of the portfolio and the investor will differ depending on the initial fees applicable, the actual investment date, and the date of reinvestment of income as well as dividend withholding tax. Forward pricing is used. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The performance of the portfolio depends on the underlying assets and variable market factors. Performance is based on NAV to NAV calculations with income reinvestments done on the ex-div date. Lump sum investment performances are quoted. The portfolio may invest in other unit trust portfolios which levy their own fees, and may result is a higher fee structure for our portfolio. All the portfolio options presented are approved collective investment schemes in terms of Collective Investment Schemes Control Act, No 45 of 2002 (“CISCA”). The fund may from time to time invest in foreign instruments which could be accompanied by additional risks as well as potential limitations on the availability of market information. The Manager has the right to close any portfolios to new investors to manage them more efficiently in accordance with their mandates. The portfolio management of all the portfolios is outsourced to financial services providers authorized in terms of the Financial Advisory and Intermediary Services Act, 2002. Standard Bank of South Africa Ltd is the appointed trustee of the Sanlam Collective Investments scheme/Standard Chartered Bank is the appointed trustee of the Satrix Managers Scheme.

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Building outcome orientated factor portfolios

Earlier in this series, we discussed how to formulate both ‘blended’ and multi-factor portfolios.

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