Currents

fall 2012 issue

Risk Factor Investing, Revealed

Building Balanced Exposure to Rewarded Risks
by KAREN WITHAM

s a traditional approach to investing

still working for you? Now may be the

Group. They have now lost confidence

that a policy concentrated on a single

time to consider optimizing your strategy

source of returns can deliver the returns

to help you reach your goalswhether

they need. We are seeing more and more

this means hitting return targets,

investors contemplate changing from a

lowering volatility, boosting funded

single factor to a multi-factor investment

ratios, or achieving other measures

strategy as they seek new ways to meet

of success. What were hearing from

their long-term goals.

institutional investors is a need for

improved performance but also for
a greater predictability of returns,
especially in an environment of
anemic economic growth.

Building Blocks for

Better Portfolios
BlackRocks research has identified
macroeconomic risk factors that influ-

In response to this new challenge,

ence the returns of asset classes. The

several years ago BlackRock started

investment team uses this information

researching how a strategy using risk

to determine the optimal portfolio

factors instead of asset classes could

allocation with reference to the risk

help investors achieve their desired

factors, then translates that allocation

outcomes. This approach, a cousin of

into asset classes. In contrast, balanced

risk parity strategies, aims to provide

allocations of bonds and equities might

more consistent returns than tradi-

appear diversified in asset class terms,

tional balanced portfolios while also

but they may not be as diversified in

limiting downside risk.

risk factor terms.

Institutional investors used to be able to

rely on the equity risk premium to achieve
their return targets, says Vincent de
Martel, a senior investment strategist
in BlackRocks Multi-Asset Strategies

A risk-factor approach helps us better

understand asset class returns and the
correlation between assets so we can
build a more diversified portfolio that
performs more consistently in different
environments, says Philip Hodges, a

The goal is to generate

higher returns, less risk,
and more consistent
portfolio performance.

FALL 2012

Vincent de Martel, CFA, is a

senior investment strategist
in BlackRocks Multi-Asset
Strategies Group.

senior member of BlackRocks risk factor

research team. We seek to extract risk
premia and then recombine them into an
optimal portfolio. The goal is to generate
higher returns, less risk, and more
consistent portfolio performance.

Philip Hodges, PhD, is a senior

member of the research team
in BlackRocks Multi-Asset
Strategies Group.

Figure 1: Risk Factor Roll Call

Asset classes are in reality a composite
of exposures to these common risk factors
Inflation-Protected Bonds

Real Rates

Nominal Bonds

Real Rates

Inflation

Corporate Bonds

Real Rates

Inflation

Credit

High Yield Bonds

Real Rates

Inflation

Credit

Liquidity

Emerging Bonds

Real Rates

Inflation

Credit

Liquidity

Political

Global Equities

Real Rates

Inflation

Economic

Liquidity

Political

So, what are these risk factors? We

think of them as the fundamental
building blocks that make up an asset

Credit

Liquidity: The risk associated with

liquidity, which is reflected in the

ability to trade an asset at low cost

class (see Figure 1 for a breakdown

and with little price impact. Even

of the risks by asset class):

typically liquid assets can be sensi-

Real rates: The risk of bearing exposure to real interest rate changes.

All cash flow instruments are subject to

this risk. Even investors who hold real
bonds to maturity are subject to markto-market and opportunity-cost risk
associated with real rate volatility.

tive to illiquidity shocks.

Political: Risk that a sovereign

government will change capital

market rules.

Economic: Risks associated with

uncertainty in economic growth.

Investments such as equities and real

Inflation: The risk of bearing expo-

estate that tend to generate poor returns

sure to changes in nominal prices.

when the economy is weak should earn

Any investment that offers a nominal

a positive economic growth premium

return rather than a real return should

compared with assets such as high-

offer an inflation premium to compen-

quality government bonds, which are

sate for this additional uncertainty.

more likely to generate positive returns

in bad economic environments.

Credit: The risk of default. Typically

this is strongly linked to economic

growth and also earns a positive premium

over time.

Currents

Redefining Diversified

BlackRocks Multi-Asset Strategies

Most portfolios have some exposure to

Group. However, by focusing on the

all six macro risk factors. However, as one

factors that drive returns rather than

example, the typical pensions exposures

asset classes, we can build a more

to these factors are skewed very high

balanced portfolio of rewarded risk

or very low, and may not reflect the

exposures. Historically, each risk factor

investors risk appetite or desire for

has been rewarded at different times,

return opportunity. Economic risk tends

so this may be a more sensible approach

to be heavily over-represented, while

to portfolio construction. (See Figure 3

typically there are just small slices of

for a look back at rewarded risks in

exposure to liquidity, credit and real

different market environments from

rates risk. (See Figure 2 for a compari-

1982 to today.)

son across various types of portfolios.)

A simple asset-class-based risk parity

For 2011, real-rates risk was by far the

most highly rewarded at around 30%

strategy is a step in the right direction as

return. Real interest rates are low at

it reduces the over-representation of

the moment, and our view is that were

economic risk, says Thomas McFarren,

going to stay in a low-growth, low-rate

a member of the research team in

regime for some time, says Hodges.

Figure 2: Balancing Act

Why use risk factors for your strategic allocation?
The average portfolio has some exposure to all six macro risk factors,
but the weights can be skewed very high or very low, and may not reflect
the investors risk appetite.

Risk Factor Exposure (%)

100

75

50

25

Typical pension
Liquidity

60/40
Political

Economic

Risk parity (45/135)

Credit

Inflation

Risk factor portfolio

Real rates

Aggregate top 200 defined benefit asset policy portfolio excludes assets classified in the survey by DB plans as
Alternatives or Other. As of February 6, 2012. The 60/40 and 45/135 portfolios assume equities are invested
in MSCI World and bonds are invested in Barclays US Aggregate.
Sources: BlackRock and Pensions & Investments.

FALL 2012

Thomas McFarren,CFA,
is a member of the research
team in BlackRocks MultiAsset Strategies Group.

The interesting question is, whats the

returns across different asset types,

next regime? If we go into a rising-rate

made intuitive sense and were accessible

environment, then this model says that

enough to enable an investor to gain or

equity-bond correlation is going to

hedge exposure to it.

increase. The portfolio that you thought

The interesting
question is, whats
the next regime?

For example, consider economic growth

was well diversified will be less well

risk, which tends to dominate most

diversified, which is why its really

investors portfolios. Our experts exam-

important to look for other sources

ination of this risk factor has led to some

of risk premia.

noteworthy observations:

Investors should consider diversifying

Research Results
and the Road Ahead

globally to capture economic growth

Risk factor investing is not new,

not necessary to forecast the fastest-

but up to this point it primarily has

growing economies to earn economic

been concentrated in equity research.

growth premia.

in as many regions as possible. It is

Emerging applications include the use

of risk factors for multi-asset investing,

Economic risk is among the bestrewarded risk factors; however,

and also for governance and setting a

investors need a premium large

strategic benchmark.

enough to justify taking on additional

The six factors highlighted here are the

risk here when theyre already exposed

result of an intensive selection process

to it through their job or business.

whereby our risk factor researchers

sought to identify the subset of factors

Equities are predominantly exposed

most relevant in explaining returns in a

diversified multi-asset portfolio. During
this filtering process, the goal was to

to economic risk but they also are

exposed to interest rate and inflation
risk, even though the exposures to
these two factors have appeared low

identify factors that reliably explained

over the past decade.

Figure 3: Rewarded Risks Vary in Different Environments

Years

Factors Best Rewarded

Post-Inflation

19821991

Inflation

Bull Market

19921999

Credit, Economic, Liquidity

Tech Bubble Collapse

20002003

Real Rates and Liquidity

Bull Market

20042007

Economic and Political

Great Recession

20082011

Real Rates

2012

???

Market Environment

The Long Recovery

Source: BlackRock, August 2012.

Currents

Deploying Diversified
Risk Strategies

something different, and

Institutional investors are using risk-

many have adopted risk

Investors are looking for

based asset allocation strategies in

factor investment strategies.

multiple ways, including as:

Doing so is not quick, or easy.

Among other things, imple-

1. A core holding,
2. An opportunistic allocation (e.g., for
educational purposes in order to explore
the impact of this type of allocation,
or as a holding on reserve for redeployment into tactical opportunities),
3. An intelligently balanced substitute

mentation takes strategic

planning, organizational
assessment and alignment
with boards; however,
the practical benefits and
insights that can result make
it an approach worth consid-

for a traditional balanced portfolio

ering in todays challenging

(e.g., defined contribution), or

and uncertain environment.

4. Part of custom-built solutions.

DEEPER DIVE
To learn more about the risk factor approach to investing and BlackRocks
macro views on the markets and economy, consider reading:
Risk Factor How-To:
Why old-fashioned
asset allocation
may thwart your
investment goals,
Currents magazine,

Currents
Quarterly Investment news from BlackRock

Hedge Fund
BreaktHrougH
three common myths exposed
diamonds in the rough
real estate for the riskaverse and yield-hungry
risk factor how-to
insider view of
scientific active
top etf trends to watch

Standing Still
Update of Our 2012

Standing Still ... But Still Standing

Update of Our 2012 Outlook
BlackRock Investment Institute
July 2012

Introducing a risk
factor approach

Outlook, BlackRock

to liability-driven

Investment Institute,

investing, Currents

July 2012.

magazine, Fall 2011.

Ask your account manager for a copy of these articles.

FALL 2012

Balancing act
introducing a risk factor approach to liability-driven investing.

But Still Standing:

Summer 2012.

Balancing Act:

SummeR 2012

by AlExiS pETrAkiS

s a strategy that could help plan

sponsors increase their funded ratio
and also reduce risk too good to be true?
Perhaps not. Adopting a risk factor
framework across all asset and liability
exposures can lead to a portfolio that
is built for positive outcomes over a
broad set of market environments. The
framework should be not only more adroit
at budgeting surplus risk, but also better
at selecting those risks that are apt to
be properly rewarded.

Sometimes its a tough sell to get plan

sponsors to adopt a new approach,
says Andy Hunt, head of BlackRocks
liability-driven investment (LDI)
capabilities in the Americas. What
were trying to demonstrate is that
there is a better way forwardone that
grows assets versus liabilities and does
not suffer the same painful setbacks
that plans have repeatedly experienced
over the past decade or so.

to equities, leaving it exposed to the risk

of large economic slowdowns. And from
a surplus perspective, there is also an
under-appreciation for the other side of
the balance sheetthe liabilities.
Numerous perfect storms for pension
plans over the past decade have taught
us that in periods of stress, diversification often fails to deliver what was hoped
for in our asset portfolios, says Dan
andy Hunt, FiA, CFA, is
Ransenberg, a strategist with Blacka member of the BMACS
team and leads Blackrocks
Rocks Multi-Asset Client Solutions
(BMACS) Group Adding insult to injury, lDi capabilities in the
Americas. Contact him at
plummeting Treasury interest rates can
[email protected]
cause pension liabilities to skyrocket at
the same time as the asset portfolio
suffers. These two insights have spawned
the risk parity and LDI strategies, respectively, that numerous sponsors are
implementing today. We think the best
way forward is to combine these
strategies and to adopt a risk factor
approach toward LDI.

UNiNteNded CoNSeqUeNCeS

ldi FRom A RiSK FACtoR woRld

Plans have always believed in diversification, but are they approaching it the
wrong way? From an asset perspective
a typical plan (say, 60% equity and 40%
bonds), is assumed to be diversified across
asset classes. However, investors have
begun to realize that capital diversification is not the same as risk diversification.
The typical 6040 portfolio allocates
greater than 90% of its asset risk budget

A typical pension plan has significant

positive (long) exposure to economic
risk and substantial negative (short)
exposure to interest rate risk. As we
have witnessed, these exposures create
problems for pension plans in economic
downturns, which catastrophically is just
when plan sponsors are most sensitive
and vulnerable. During these periods of
tumult, economic risk is not rewarded,

Currents
Published by BlackRock, Inc.
Please direct story ideas,
comments and questions to:
Marcia Roitberg, editor
Telephone 850-893-8586
Facsimile 415-618-1455
[email protected]

Find Currents on the web at

blackrock.com/currents
To subscribe, visit
blackrock.com/subscribe/currents

The information included in this material has been

taken from trade and other sources considered
reliable. No representation is made that this information is complete and should not be relied upon
as such. Any opinions expressed in this material
reflect our judgment at this date and are subject to
change. This material is not intended to provide
investment advice. No part of this material may be
reproduced in any manner without the prior written
permission of BlackRock, Inc.
The strategies referred to herein are among various investment strategies that are managed by
BlackRock, Inc., and its subsidiaries (together,
BlackRock) as part of its investment management
and fiduciary services. Strategies may include collective investment funds maintained by BlackRock
Institutional Trust Company, N.A., which are available only to certain qualified employee benefit
plans and governmental plans and not offered to
the general public. Accordingly, prospectuses are
not required and prices are not available in local
publications. To obtain pricing information, please
contact a defined contribution strategist. Strategies
maintained by BlackRock are not insured by the
Federal Deposit Insurance Corporation and are not
guaranteed by BlackRock or its affiliates.

Investing involves risk, including possible loss of

principal. Past performance does not guarantee
future results.
In Canada, this material is intended for accredited
investors only. This material is provided for informational purposes only and does not constitute a
solicitation or offering of shares or units of any
fund or other security in any jurisdiction in which
such solicitation or offering is unlawful or to any
person to whom it is unlawful.
For Institutional and Professional Clients in Latin
America only. This material is solely for educational
purposes only and does not constitute an offer or a
solicitation to sell or a solicitation of an offer to
buy any shares of any securities (nor shall any
such securities be offered or sold to any person) in
any jurisdiction within Latin America in which an
offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction.
No information discussed herein can be provided
to the general public in Latin America.
2012 BlackRock, Inc. All rights reserved.
BLK-0380 5275_R4_v01AG_9/12

For institutional use only

not for public distribution

blackrock, Inc.
400 Howard Street
San Francisco, CA 94105

blackrock.com

RISK FACTOR VALUATIONS

All asset classes share exposures to common risk factors. When one or several factors move out of
their long-term normal valuation range, the asset classes that are exposed to them are faced with
greater than normal upside or downside risk. For maximum diversification, investors should hold a
balanced exposure to all risk factors that are expected to deliver positive returns in the long run.
Here we present one way of looking at the potential returns of six risk factors and compare the risk
premia for June 2012 vs. June 2011 to show how (and if) things have changed.

Extremely
expensive (low
expected returns)
1

At fair longterm value

0

Extremely
cheap (high
expected returns)
1

1
2

1
2

June 2012

Political
June 2011

Source: BlackRock analysis, as of June 30, 2012.

Economic

Credit

Inflation

Real Rates
1

1
2

Liquidity