Monday, April 29, 2019

Drilling Down for Diversification: 

Diagnostics help investors see beyond the asset-class level through a factor lens, identify unintended risk


By Nicholas Savoulides and Jacob Borbidge, Guest Contributors

Asset owners and their managers are always striving for a portfolio that, on the whole, is greater than the sum of its parts. That’s a driving force behind the quest for diversification – a portfolio, viewed holistically, that has less risk than its individual components. Often, conversations about diversification begin and end at the asset class level. Today’s investors, however, have the opportunity to create a clearer, truer picture of diversification.

Asset-class level diversification remains important and cannot be ignored; however, diversifying across common attributes of securities within each asset class is now possible, due in part to factor-based analytics. Today we have a much more robust set of factors available that are investible, both on the equities and fixed-income side – think long-only, long-short, commodities, and alternative asset classes, for example. With a broader set of tools that can be implemented into portfolios, we can think about diversification at a deeper level and add the lens of factor diversification to the overall portfolio construction equation.

When factors are employed, an investor can assess a portfolio for value (to pick a factor) across the entire asset allocation, opening up new avenues that can reduce the correlation of strategies within the portfolio even further. That’s really the end goal of diversification – to drive down the average correlation within your portfolio by selecting investments that behave less like other investments in the portfolio. As long as you continue to include assets with lower correlation to existing investments, you’re going to increase diversification.

Investors’ goals are the starting point

One way of thinking about achieving diversification by using factors and related diagnostics is to compare asset allocation to complex surgery. The first thing a surgeon takes into consideration before planning the procedure is a simple question: What is the desired outcome? Investors typically have clear goals, and once those are identified, factors are the foundation upon which we start building the most appropriate solution to best achieve the metrics that the client is trying to maximize. Maybe the goal is to reduce the funding ratio volatility. In that case, as we’re calculating the risks and trying to see how we’ll best achieve the desired outcomes, we use the appropriate tools and analytics to perform the diagnostic. To the investor, factors sit behind the scene in this process, but they allow us to be more precise in our calculations, and to propose a solution that is much closer than if we stopped at the asset-class level.

Factors provide additional color in terms of expectations. Let’s say an asset owner has an equity-heavy portfolio and believes they are positioned to do well in a strong equity market. Factor analysis may show they are heavy from a defensive factor-exposure standpoint ­– so in fact, if equities win, they may lose. With the additional factor lens to assess their portfolio we can say, ‘Here's what you expect to happen; here’s what analytics show—are those two things aligned?’ That sparks the discussion of how to pivot and create alignment. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Invesco or TEXPERS. 

About the Authors:
Nicholas Savoulides
Jacob Borbidge

Nicholas Savoulides is the head of global solutions research and portfolio analytics at Invesco. In this role, he works with internal and external audiences to set the firm's solutions research agenda and develop solutions-enabling capabilities. Savoulides' team efforts span the pillars of portfolio analytics, strategic asset allocation modeling, and framework and tool development. Prior to joining Invesco in 2016, Savoulides spent nine years with Loomis Sayles, where he led the company's liability-driven investing solutions initiative while serving as a portfolio manager on several long-duration fixed income strategies. He has also worked as a consultant with The Boston Consulting Group. He earned his bachelor's degree, master's degree and doctorate in aeronautics and astronautics, with a minor in finance, from MIT. He is a Chartered Financial Analyst charterholder and is a member of the Boston Security Analysts Society.

Jacob Borbidge is a portfolio manager and the head of research for the Invesco Global Solutions Development and Implementation team, which provides customized multi-asset investment strategies for institutional and retail clients. In this role, Borbidge is responsible for directing the research and portfolio implementation efforts of the team’s investment process. This involves setting the research agenda, defining portfolio implementation methodology, and providing in-depth presentations of the investment process to internal and external teams. Previously, Borbidge spent 10 years as an analyst for the Invesco Global Quantitative Strategies team. Prior to joining Invesco in 2004, he was a mechanical engineer with ExxonMobil. Borbidge earned a bachelor's degree in mechanical engineering from Lehigh University and a master's degree in finance from the University of Houston. He is a Chartered Financial Analyst and Chartered Alternative Investment Analyst charterholder, and he regularly lectures on the topic of quantitative finance for the graduate program at the University of Houston.

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