The shock of asset class correlations going to one during the global crisis has prompted new ways to look at asset allocation among institutional investors and managers, which have started to drill down into the risk factors driving markets. Investors should look beyond asset class diversification and analyse the risk factors driving returns – and, crucially, how these factors behave during market crises – as they structure portfolio defences, according to PIMCO’s Bruce Brittain. There are three risk factors that “matter” in asset allocation, Brittain, a member of PIMCO’s product management group, said. They were equity, the level of interest rates, and the slope of yield curves. Credit risk, he said, was a derivative of equity risk. “We try to encourage investors not to think in asset class directions but in risk factors. But it’s instructive to go through asset classes and undo the risk buckets that drive returns,” Brittain said.
These factors drive the performance of “traditional” equity and bond portfolios, and also “endowment-style” funds investing in multiple asset classes, including large allocations to illiquid assets. Brittain compared the risk exposures of a portfolio with a 60 per cent allocation to the MSCI World index and 40 per cent to global bonds, with that of an “endowment-style” portfolio holding 15 per cent exposures in each of the following asset classes: US equities, global equities, US bonds, private equity and absolute return; 10 per cent to real estate; and 5 per cent apiece in emerging markets equity, venture capital and commodities. Despite the sweeping differences in asset allocation, the risk exposures of both portfolios were strikingly similar. The traditional portfolio was 97 per cent exposed to broad equity risk and 3 per cent to a category termed ‘other’, while the endowment-style fund was 87 per cent exposed to broad equity risk, 7 per cent to currency, 3 per cent to commodity, 2 per cent to real estate and 1 per cent to the “other” category.