QFIP-143: Risk Factors as Building Blocks for Portfolio Diversification

Question 1

Define risk factors in the context of portfolio construction.

Answer 1

• Factors - the basic building blocks of asset classes and a common source of risk exposure across asset classes
• Factors - the smallest systematic (or nonidiosyncratic) units that influence investment return and risk characteristics

Question 2

Describe how to get exposure to the following risk factors:

1. Inflation
2. Real interest rates
3. Volatility
4. Value
5. Size
6. Credit spread
7. Duration
8. Developed Economic Growth

Answer 2

1. Inflation - long a nominal Treasuries index, short a TIPS index
2. Real interest rates - long a TIPS index
3. Volatility - long the VIX futures index, TVIX, etc.
4. Value - long a developed country equity value index, short a developed country growth index
5. Size - long a developed country equity small-cap index, short a developed country equity large-cap index
6. Credit spread - long a US high-quality credit index, short a T-bill/bond/note
   
   • You gain on high qual credit index if credits tighten and overall economy improves
7. Duration - long a T-bond (long-term), short a T-bill (short-term)
8. Developed Economic Growth - long the MSCI World Index

Question 3

State the key equations for the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT).

Answer 3

• One of the main insights of the model is that there are diversification benefits if
  correlation < 1
• Portfolios are described as efficient if they provide the greatest expected return for a given level of expected risk
• Arbitrage Pricing Theory (APT) is a multi-factor extension of the Capital Asset Pricing Model (CAPM)
  
  • Verbally, this means that the expected return of a given asset can be decomposed into the sum of:
    
    • The risk-free rate
    • The risk factors weights multiplied by the risk premiums
• These approaches rely heavily on inputs AND the inputs are difficult to estimate

Question 4

A cash investment can be decomposed into which two risk factors?

Answer 4

1. Real interest rates
2. Inflation

Question 5

Compare ex-ante and ex-post estimation.

Answer 5

• Ex-ante estimation
  
  • Prospective
  • Based on forecasts rather than actual results
• Ex-post estimation
  
  • Retrospective
  • Example: Creating a matrix of expected returns based on historical data

Question 6

Describe capital accumulation and provide examples of assets using this investment approach

Answer 6

• Description: Growth assets, relatively high long-term returns
• Examples: Global public equity, private equity, equity-like instruments

Question 7

Describe absolute return and provide examples of assets using this investment
approach

Answer 7

• Description: Strategies intended to benefit from skillful active management, earn returns between stocks and bonds while attempting to protect capital
• Examples: Absolute return hedge funds, other absolute return investments

Question 8

Describe flight to quality and provide examples of assets using this investment
approach

Answer 8

Description: Low-risk assets, protect capital in time of market uncertainty
Examples: Cash, cash equivalents, U.S. fixed income, investment grade bonds,
government obligations

Question 9

Describe inflation-linked investing and provide examples of assets using this
investment approach.

Answer 9

• Description: Real assets that support purchasing power
• Examples: Real estate, real assets, TIPS

Question 10

What are the three LDI approaches mentioned in the “Risk Factors as Building Blocks” reading?

Answer 10

• LDI 1.0: Long-duration bonds
  
  • Consists of simply extending bond duration and using traditional
    bond benchmarks for the liability-hedging portfolio
• LDI 2.0: Long-duration bonds with derivatives
  
  • Involves a more sophisticated liability hedge, one that uses
    factors to match specific liability characteristics, including duration and credit qualit
• LDI 3.0: Risk factors
  
  • which uses a detailed analysis of risk factors, could possibly
    have a more granual hedge that understands exposures better. This approach features a more granular expression of the liability enchmark. It uses an expanded collection of risk factors and constructs the return-seeking portfolio with factors to prevent overlap with the liability hedge

Question 11

State key advantages of the factor-based approach for portfolio construction

Answer 11

• Illuminates sources of risk
• Enhances the way of monitoring exposures
• Attributes risk on the level of asset classes and the level of individual strategies
• Provide a useful way to group traditional classes into macroeconomic buckets
• Simple insights, such as the relationship between equity and credit, are reinforced by analyzing factors
• More complex interactions can be expressed with greater clarity through the lens of risk factors
• Can shed new light on the multifaceted relationships between active strategies
• Informs manager structure analysis
• Factors can, theoretically, be remixed into portfolios that are better diversified and more efficient than traditional methods

Question 12

State key disadvantages of the factor-based approach for portfolio construction.

Answer 12

• The process of identifying a set of significant/appropriate factors is subjective and can be challenging
• The mapping process from factors to investable instruments can be cumbersome
• Active, frequent rebalancing
• Difficult to quantify expected return parameters
• Use of derivatives/short positions
• Transaction costs (and other practical details) introduce technical difficulties

One hybrid approach is to examine asset classes through a factor lens during the policy portfolio construction process and group like asset classes together under various macroeconomic
scenarios

Question 13

What are the common risk factors for US Equity?

Answer 13

1. Volatility
2. GDP Growth
3. Size
4. Value
5. Liquidity
6. Momentum
7. Currency
8. Inflation

Question 14

What are the common risk factors for US Corporate Bonds?

Answer 14

1. Inflation
2. Capital Structure
3. Volatility
4. Currency
5. Real rates
6. Liquidity
7. Default Risk
8. Duration

Question 15

What are the key macroeconomic risk factors?

Answer 15

1. GDP Growth
2. Productivity
3. Real interest rates
4. Inflation
5. Volatility

Question 16

What are the key regional risk factors?

Answer 16

1. Sovereign Exposure
2. Currency
3. Emerging Markets

Question 17

What are the key developing economic growth risk factors?

Answer 17

1. Size
2. Value
3. Momentum

Question 18

What are the key fixed income risk factors?

Answer 18

1. Duration
2. Convexity
3. Credit spreads
4. Default risk
5. Capital structure

Question 19

Which assets relatively outperform in a high growth/high inflation macroeconomic
scenario?

Answer 19

Real assets:

• Real Estate
• Timberland
• Farmland
• Energy

Question 20

Which assets relatively outperform in a low growth/low inflation macroeconomic
scenario?

Answer 20

• Cash
• Government bonds

Question 21

Which assets relatively outperform in a high growth/low inflation macroeconomic
scenario?

Answer 21

• Equity
• Corporate Debt

Question 22

Which assets relatively outperform in a low growth/high inflation macroeconomic
scenario?

Answer 22

• TIPS
• Commodities
• Infrastructure

Question 23

State the shortcomings of traditional mean variance optimization (MVO).

Answer 23

• Inputs are difficult to estimate, and small changes in inputs can cause large changes in results
  
  • In particular, the expected return parameters will have a large impact on the optimal portfolio weights. Unforunately, the expected return parameters are the most difficult to estimate
• With different capital market expectations and risk-free rates, the most appropriate strategic asset allocation may not be optimal
• Assumes variance is a complete measure of risk
• Does not break down risk into the smallest building blocks, and so correlations and interactions between risks may not be fully understood

Question 24

Evolution of LDI

Answer 24