The Chemistry of Asset Allocation

(February 6, 2013) — For chief investment officers charged with creating a diversified portfolio, a factor-based investment approach is the way to go, claims Eugene Podkaminer of Callan Associates.

“A factor-based investment approach enables the investor theoretically to remix the factors into portfolios that are better diversified and more efficient than traditional portfolios,” he says in a paper published by the CFA Institute.

The challenge of this approach, however, is largely the need for active, frequent rebalancing, forward-looking assumptions, and the use of derivatives and short positions.

The author–Callan’s vice president of capital markets research–defines “factors” as the basic building blocks of asset classes and a source of common risk exposures across asset classes. “Factors are the smallest systematic (or nonidiosyncratic) units that influence investment return and risk characteristics. They include such elements as inflation, GDP growth, currency, and convexity of returns,” the author writes. “In a chemistry analogy: If asset classes are molecules, then factors are atoms. Thus, factors help explain the high level of internal correlation between asset classes.”

According to Podkaminer, the application of risk factors to policy portfolio construction is relatively new, with areas for further research including identifying a set of significant factors, mapping this set to investable instruments, developing a forward-looking return forecasting methodology, and considering transaction costs.

Efforts among institutional investors to overhaul their traditional investment philosophies are numerous. California’s roughly $157.8 billion teachers’ pension fund has been seriously considering following the growing trend among asset owners of kicking the asset bucket in favor of risk-based allocation.

In January, for the third board meeting in a row, the California State Teachers’ Retirement System (CalSTRS) discussed the pros and cons of a six-point (plus sub-sections) risk class framework. Neil Rue, a managing director at Pension Consulting Alliance (PCA), CalSTRS’ private equity consultancy, presented the new model, which could be used alongside asset class buckets. However, if the committee preferred it to the traditional framework, PCA and staff could “deftly make the switch”—which PCA recommended they do. “From a quantitative modeling perspective, the risk-class framework is a better solution for organizing your assets at the highest level,” Rue said at the time. “The arguments for risk classes is pretty strong here…We propose you move in that direction in a major way.”