Factor Investing And Risk Allocation: From Traditional To Alternative Risk Premia Harvesting
Academic research (see Ang (2014) for a synthetic overview) has highlighted that risk and allocation decisions could be best expressed in terms of rewarded risk factors, as opposed to standard asset class decompositions, which can be somewhat arbitrary. For example, convertible bond returns are subject to equity risk, volatility risk, interest rate risk and credit risk. As a consequence, analyzing the optimal allocation to such hybrid securities as part of a broad bond portfolio is not likely to lead to particularly useful insights. Conversely, a seemingly well-diversified allocation to many asset classes that essentially load on the same risk factor (e.g., equity risk) can eventually generate a portfolio with very concentrated risk exposure. More generally, given that security and asset class returns can be explained by their exposure to pervasive systematic risk factors, looking through the asset class decomposition level to focus on the underlying factor decomposition level appears to be a perfectly legitimate approach, which is also supported by standard asset pricing models relying on equilibrium arguments (the Intertemporal CAPM from Merton (1973)) or arbitrage arguments (the Arbitrage Pricing Theory from Ross (1976)).