March 2016 | Download PDF
The essence of portfolio management has traditionally been framed in terms of asset classes, countries and sectors, with tactical asset allocation and risk management best described as the process of managing these exposures. While this is a valid way of viewing markets, there is another dimension that investors are increasingly focused on: factor exposures, in other words, persistent drivers of return in the equity market, such as value, quality, momentum, size and volatility.
Factor exposures come in a variety of flavors, but all provide a different prism through which to view return and risk. By adding a factor overview, investors can help isolate risks such as interest rate or economic sensitivity that cut across various asset classes. In addition, factors provide another mechanism for viewing country and sector bets.
As investors tilt toward specific sectors, countries or themes, they are also exposing their portfolio to various factors. In some cases, these exposures may be inconsistent with an investor’s forecast of the economic or financial environment. Awareness of how these exposures might manifest in a portfolio is critical for helping to ensure that a portfolio is built in a way that is consistent with an investor’s market views. To the extent that the portfolio is tilted in unintentional ways, there is an increasing array of tools and instruments that can be employed to fine-tune the allocations.
Investors may also want to consider adjusting their portfolios’ exposures based on their expectations for the economic climate. Historically, returns to the various factors have been at least partly driven by such conditions as growth, inflation and volatility. Just as with sectors or countries, investors may want to consider tilting their portfolio toward or away from these factors as another potential source of return or another mechanism for managing risk.