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Risk factors are the building block of factor investing. A risk factor is an underlying characteristic or exposure that can be used to explain the return profile of an asset class.
The return profile of a bond, for example, is tied to risk factors such as duration, credit spreads and default risk, while a stock’s returns are linked to factors such as size, value and momentum. Macroeconomic risk factors include volatility and inflation.
Risk factors were first proposed in academic financial models such as the capital asset pricing model (CAPM) which expresses the relationship between expected return and risk for stocks, and Stephen Ross’s 1976 arbitrage pricing theory which asserts that an asset’s returns can be predicted by its relationship with common risk factors.
During the 2008 financial crisis, the traditional method of diversifying portfolios by investing in different asset classes proved to be less effective than investors anticipated, as previously uncorrelated asset classes began to move in tandem. As a result, factor investing has emerged as an alternative to traditional asset class allocation for generating risk-adjusted returns.
Risk factor-based allocation works by determining the underlying risk exposures that contribute to each asset’s returns, and then selecting assets based on those exposures, to create a portfolio that best reflects the investment thesis while simultaneously diversifying risk. For example, in order to gain exposure to currency risk, a portfolio manager could invest directly in currencies, or gain exposure indirectly though assets that are exposed to the same risk factors.
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