Equity Portfolio Construction – Through a Risk Factor Lens

June 28, 2018  | by David Scarozza

Equities | Industry Knowledge | Investment Strategy | Market Commentary | Risk Management

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.

Authors

X
David Scarozza is a member of the Investment team and is responsible for constructing portfolios that have the objective of outperforming passive equity alternatives. David is also primarily responsible for Commmonfund’s hedge fund portfolio which is used as a diversifying active risk and alpha source within equity portfolios and in the context of a total portfolio. Prior to this role, David was a Managing Director on the hedge fund team and prior to joining Commonfund, he served as a Vice President and the senior manager analyst on Citigroup′s fund of funds team. David received a B.A. in Economics from Swarthmore College, completed a one-year program of study at the London School of Economics and received an M.B.A. from Columbia University.
David Scarozza
Managing Director, Head of Equities

Subscribe to Insights Blog

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. 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. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. 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 Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or 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. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. 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. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. 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 Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or 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. Past performance is not indicative of future results. For more information please refer to Important Disclosures.