Risk factors are components of asset-class returns; analyzing them gives a more detailed and reliable picture of what's driving returns. For example, returns of high-yield bonds, which might sit in a bond portfolio, are driven as equity factors in addition to credit ones.
James Moore, managing director and co-head of investment solutions at Pacific Investment Management Co., Newport Beach, Calif., said a colleague uses the analogy of a Mexican restaurant to explain risk factors. Although the restaurant's menu lists many dishes, each contains the same seven or so ingredients used in various proportions.
Large pension plans and sovereign wealth funds such as the $240.5 billion California Public Employees' Retirement System, Sacramento; the $39.9 billion Alaska Permanent Fund, Juneau; and the 220.8 billion Swedish kronor ($34.9 billion) AP3, Stockholm, have adopted factor-based asset allocation approaches.
However, implementation is “very difficult to do on your own without the proper systems,” GSAM's Mr. Baillie said.
Interest is growing because risk factors allow investors to understand more clearly what's driving returns. Plus, they can aid diversification and enhanced downside protection.
“After the crisis in 2008, investors really took to heart that diversification in capital terms is not equivalent to diversification in risk terms,” Kevin Kneafsey, managing director and head of research for BlackRock's multiasset client solutions group in San Francisco, said in an e-mailed response to questions.
“In reality, balanced portfolios such as 60% equities/40% bonds allocate about 90% of their risk budget to equities. This leaves them exposed to the risk of large economic slowdowns, which have happened twice over the past decade.”
Investors are searching for new risk management tools, and looking to managers for help, said Anthony Werley, managing director and chief strategist, endowment and foundations group, at J.P. Morgan Asset Management, New York. “After 2008 and 2009, people are saying to themselves, "We need to get a better handle on the risks we're taking.' ” Mr. Werley wrote a white paper titled, “Factor Risk Management: A Generalized Methodology for Multiasset Class Portfolios,” last week. He hopes endowments and foundations will migrate to using a factor-based allocation approach.
“The most sophisticated endowments and foundations are certainly familiar with it and some are using it. But this isn't a widely dispersed tool,” he said. JPMAM offers clients use of its factor model. “We're not here to charge a fee for the analysis,” he said. “We want that to lead to a deeper relationship” with the client.
Said PIMCO's Mr. Moore: “The solutions effort is in large part about knowledge-sharing on a two-way street. Obviously we have a depth of resources ... but also what's very valuable to us is that it helps us better understand our clients.” That knowledge can be used to develop strategies with wider appeal, or to prioritize timing of new strategies, he said.
“Clearly there's a big shift to a more complete offering on the asset manager side,” Frank Nielsen, New York-based executive director and head of index and applied research-Americas at MSCI Inc., said in an interview. “For those kinds of mandates, the challenge is to show they are capable of managing the risks.”
Risk management has greatly improved since the global financial crisis, Mr. Nielsen said. In December 2009, MSCI released a survey showing that money managers and institutional investors were scrambling to boost their risk management capabilities. At the time, Mr. Nielsen said that claiming to have cross-asset-class risk management capabilities “was more of a marketing function” than reality.
Since then, “we have seen a strong trend to improve internal risk management capabilities at asset management firms, including cross-asset-class and firm-wide assessment of investment risks,” Mr. Nielsen said in an e-mailed response to questions.
In addition to offering risk analysis as way to develop closer ties with investors, managers are using factor analysis in customized multiasset strategies or solutions.