GHP Library

In search of higher returns at current risk levels, institutional investors have expressed intense interest in further

diversifying seemingly staid, “traditional” asset allocations constructed using asset class inputs with mean variance-optimization (MVO) tools. During the past decade, institutional investors have augmented public fixed income and equity allocations with a wide range of strategies—including full and partial long/ short, risk- parity, and low-volatility strategies—and have enlarged

allocations to alternative strategies. However, comparatively little has been accomplished at the overall policy level; for most investors, asset classes remain the primary portfolio building blocks.

In this article, I explore portfolio construction by using risk factors, also referred to as “risk premia,” as the basic elements. Theoretically, this approach may result in lower correlations between various portfolio components and may lead to more efficient and diversified allocations than traditional methods. However, the practical limitations of policy portfolios constructed with risk factors are significant enough that few investors are embracing full-scale implementation. Yet, much of the intuition of risk factor portfolios can be used to refine and augment traditional allocations and offers a holistic and succinct manner to diversify portfolio risk.