Equity Portfolio Construction – Through a Risk Factor Lens

June 28, 2018 |
2 minute read
|

At Commonfund, we aim to build multi-manager, active risk equity portfolios with a clear objective of consistent outperformance versus passive policy benchmarks. Our approach is to take intentional and measured “risk away from the benchmark” by allocating to a variety of managers who employ active risk strategies that are uncorrelated to one another. We view the investment universe through a risk factor lens and have the quantitative capabilities and machine learning techniques to measure the various risks existing managers bring and potential managers might bring to our portfolios. Under our microscope, we disentangle, map and tally “risk away from the benchmark” quite specifically to known risks such as: market risk (i.e., simple beta exposure), regional risk (relative country bets) factor risks (like value or growth), sector risks (like healthcare or financials) and idiosyncratic risk (security specific risk that is difficult to attribute to the aforementioned). We do this at the underlying manager level and then at the aggregate multi-manager portfolio level.

Big Deal! So what? Well, we think it’s a big deal because we prefer some risk types to others and this factor lens gives us the ability to differentiate and, thus, build “intentional” active risk equity portfolios. For instance, we value idiosyncratic risk highly as it provides significant diversification value and alpha potential. Conversely, we seek to control and limit risk factor exposures that can bubble up across stock portfolios and create risk redundancies if left unchecked. Furthermore, we seek out and build into our portfolios non-traditional risk factor premiums that do not typically occur in traditional stock picking portfolios: these also offer diversification value in addition to potentially uncorrelated excess return sources. Finally, we risk weight our allocations across managers such that no single allocation (or cross-manager redundant risk factor) should drive total portfolio excess return over any reasonable length of time.

Why do we pay such close attention to factor risks? We do so because factor exposures have the potential for unpredictable and significant market moves that can quickly offset hard fought alpha production. Let’s consider value and growth factors and explore the ramifications of an investor being over / under exposed to one or the other as an active risk source over the last 12 months and over time more generally.

The following chart shows rolling 12 month returns of the Russell 1000 Growth Index minus the Russell 1000 and the Russell 1000 Value Index minus the Russell 1000, isolating the growth and value factors in large cap U.S. equities over time. Over the 12 months ending February 28, an allocation to growth was worth 8% more and to value 8% less than a simple allocation across the diversified index. Great news if your institution had intentionally (or unintentionally, for that matter) chosen a growth bias and awful news if the opposite. In either case, it’s difficult to know when to reverse the trade. Looking back further over time, one sees significant variation and directionality across both of these factors. Our research, and indeed the research of many other market participants, has shown that investors do not generally demonstrate repeatable edge in factor timing. Therefore, we aim to measure, limit and diversify the amount of active risk return variation our portfolios experience directly from factor exposures.

Equity Portfolio Construction - Isolating Value vs Growth

In a competitive active equity management landscape, where 100 basis points a year over a benchmark puts you amongst the top quartile of a peer group, every basis point counts. Recognizing this, 800 basis points of risk away from the benchmark resulting from a factor bet where significant edge is not apparent represents a risk we aim to limit.

The intended outcome of allocating risk in such a measured and controlled manner is that the volatility of our active return versus the benchmark should be fairly tight and the sources of that volatility will be readily identifiable. Furthermore, a greater percentage of our excess return should be driven by the idiosyncratic risks our managers bring to the portfolio, where we believe they possess explainable “edge” in their approach and thus also a greater chance of repeatable success, rather than from factor exposures whose predictability of returns are more capricious.

Visit our Commonfund Research Center to learn more about risk management. 

Commonfund

Author

Commonfund

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

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Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.