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Asset Class Diversification Is Not the Same as Risk Factor Diversification

Learn why identifying underlying risk factors is critical even in highly diversified portfolios.

Even highly diversified portfolios may not adequately cushion market volatility. Understanding the underlying risk factors that many asset classes share can help investors create a more efficient, risk-managed portfolio.

What these charts show

Portfolios may contain unintentional risk. The portfolio shown here is broadly diversified across asset classes, but in fact has a very concentrated exposure to underlying equity risk.

What it means for investors

Portfolio solutions need to take an allocation approach that looks beyond asset class labels and focuses instead on risk factors – the underlying risk exposures that ultimately drive investment returns.

The pie chart is a hypothetical asset allocation breakdown of a broadly diversified portfolio. The allocations by market value weight are (from largest to smallest): global equities (50%), fixed income (20%), private equity (8%), hedge funds (7%), real estate (7%), TIPS (3%), global bonds (2%), cash (2%) and commodities (1%). 

The pie chart is a hypothetical risk allocation breakdown of a broadly diversified portfolio. The allocations by contribution to estimated volatility (from largest to smallest): world equity developed (82%), world equity emerging markets (9%), corporates (4%), currency (4%) and other factors (1%).

What this chart shows

Different asset classes often share the same underlying risk factors, which explains the majority of their returns. The chart shows the degree of various risk factor exposure across asset classes. For example, broad equity risk factors are present in a wide range of investments.

What it means for investors

A truly diversified strategy should look beyond asset class labels – first identifying risks that deliver the best return potential, and then selecting a mix of asset classes that provide the most efficient exposure to those risks. This allows investors to avoid risk factors believed to be overvalued or carrying excessive downside potential.

The table breaks down the variation in risk factors (equity, interest rate, credit, currency and momentum) by assets classes (equities, developed market bonds, emerging market bonds, commodities, real estate, currencies).

Disclosures

A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

The asset class exposure model presented herein for illustrative purposes only. The allocation model is based on: ■Global Equities represented by MSCI All Country World (ACWI) Index. ■Fixed Income represented by Bloomberg Barclays U.S. Aggregate Index. ■Global Bonds represented by Bloomberg Barclays Global Aggregate USD-Hedged Index. ■TIPS represented by Bloomberg Barclays U.S. TIPS Index. ■Private Equity represented by Cambridge Associate U.S. Private Equity. ■ Hedge Funds represented by HFRI FOF: Diversified Index. ■Real Estate represented by NCREIF Property Index. ■Commodities represented by Bloomberg Commodity TR Index. ■Cash represented by 3-Month USD Libor Index.

VOLATILITY (ESTIMATED)
We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2017 PIMCO.

CMR2017-0608-273301