Professor Amin Rajan at CREATE Research has put questions to institutional investors for years. And each year he publishes an independent report on the global investment industry. From the interviews he has conducted so far in 2011, Rajan says the theme of this year’s report will be innovation. It’s fitting that investors have this subject front-of-mind, given that “crisis is the mother of innovation,” he says. In search of ways to improve the way they invest, some pension funds have adopted new asset allocation strategies focused on underlying risk factors instead of asset ‘buckets’.
The financial crisis showed how their portfolios, broadly diversified across asset classes, were exposed to just a handful of risk factors. Andrew Ang at Columbia University uses food in an analogy to convey the approach. “Factors are to assets what nutrients are to food,” he writes. “Assets are bundles of different types of factors, just as foods contain different combinations of nutrients.” In essence, returns reflect the underlying risk factors of assets, and large investors should no longer seek “naïve diversification” across asset classes. Before the financial crisis, the US$231 billion CalPERS was one of the most diversified investors around. But this didn’t help all that much: the fund lost US$100 billion from October 2007 to March 2009, when its portfolio bottomed at US$160 billion.
This experience spurred the fund to follow Dutch fund ATP and the Alaska Permanent Fund in taking on the risk-oriented approach to asset allocation. Its portfolio is now invested in five risk factors: income, growth, real, inflation-linked and liquidity. The growth portfolio, for example, consists of investments in public and private equities. Investing in this way has not caught on in Australia: the $71 billion Future Fund, the $37 billion AustralianSuper and the $35 billion Victorian Funds Management Corporation continue to allocate by asset type, rather than risk factor. Rajan says the risk-based approach is a “very nuanced” way to invest. “It’s about insights and foresights. Not one of methodical rules.” No strategy is bulletproof, but if the factor approach increases investors’ awareness of risk concentrations in their portfolios, it could inform a better defence against future market routs.
