Understanding Investing

Risk Factor Diversification

Traditional portfolio construction approaches, which focus on asset class diversification, may fall short of investors’ goals. A more efficient diversification strategy may be to allocate across the underlying “risk factors.”

Why isn’t traditional asset class diversification enough?

Traditional allocation strategies seek to mitigate overall portfolio volatility by combining asset classes with low correlations to each other, meaning that they tend not to move in the same direction at the same time. However, asset class correlations are less stable than many investors realize, and long-term trends such as globalization are driving correlations higher. In addition, correlations typically increase during periods of market turbulence. As a result, seemingly distinct asset classes are likely to behave more similarly than many people expect. In other words, even portfolios that are well diversified across asset classes may not be positioned to adequately diversify and cushion market volatility (Figure 1).

There are two pie charts: The top 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%), global bonds (2%), TIPS (3%), private equity (8%), hedge funds (7%), real estate (7%), commodities (1%) and cash (2%). The bottom pie chart is a hypothetical risk allocation breakdown of the same broadly diversified portfolio. The allocations by contribution to estimated volatility (from largest to smallest): world equity developed (80%), world equity emerging markets (9%), corporates (4%), currency (6%) and other factors (1%). 

What is a risk factor?

Risk factors are the underlying risk exposures that drive the return of an asset class (see Figure 2). For example, a stock’s return can be broken down into equity market risk – movement within the broad equity market – and company-specific risk. A bond’s return may be explained by interest rate risk – price sensitivity to changes in rates – and issuer-specific risk. And currency risk is a factor for assets denominated in foreign currencies. By targeting exposure to these underlying risk factors, investors can select a mix of asset classes that provides more diversified portfolio risk.

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).

How does risk factor-based allocation work?

While it’s not possible to invest directly in a “risk factor,” using an allocation strategy based on risk factors can help investors more effectively choose a mix of asset classes that best diversifies their risks while also reflecting their views on the global economy and financial markets. How would such a strategy work? By understanding the underlying risk factors within various asset classes, investors can ultimately choose which asset class allows them to most efficiently obtain exposure to that particular risk factor. For example, if they wished to add foreign currency risk to their portfolio, they could do so by investing directly in currencies, but they could also consider foreign equities, bonds or even commodities, if valuations seemed more attractive among those asset classes. Over time, that flexibility can help add significant value to a portfolio.

How can investors apply risk factor-based diversification to their portfolios?

Using a risk factor-based approach requires a forward-looking macroeconomic view on a wide range of variables, including monetary policy, geopolitical developments, inflation, interest rates, currencies and economic growth trends. Because few individuals have the resources or infrastructure to continually monitor these factors, it may make sense for them to talk to their financial advisors about funds that use such an approach.


All investments contain risk and may lose value. Diversification does not ensure against loss. Investors should consult their investment professional prior to making an investment decision.

The asset class exposure model presented herein for illustrative purposes only. The allocation model is based on: S&P 500 (U.S. Equities), MSCI EAFE Net Dividend Index in USD (International Equities), MSCI Emerging Markets Index (Emerging Market Equities),Barclays Capital US Aggregate Index (U.S. Bonds), HFRI Fund Weighted Composite Index (Absolute Return), Dow Jones UBS Commodity TR Index (Commodities), Cambridge Associates LLC U.S. Venture Capital Index® (Venture Capital), Cambridge Associates LLC U.S. Private Equity Index® (Private Equity), NCRIEF Property Index (Real Estate). It is not possible to invest directly in an unmanaged index.


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.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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