Most investment portfolios are a collection of risk factors, such as exposure to credit and equity risk. Monitoring and managing these factors is critical. The standard approach is reviewing portfolios through a plain-vanilla asset allocation lens – 60% stocks, 30% bonds, 10% cash, for instance. But the standard methodology is a blunt instrument. For a clearer view of what’s driving your portfolio, decomposing risk with factor-based analysis offers a higher level of insight.
The stakes are high because the sources of risk and return in a portfolio can remain hidden in a conventionally designed asset-allocation review. That’s a problem for the simple reason that if you’re in the dark about the risk profile of your investment strategy, effective risk management is harder and perhaps even impossible. Fortunately, there’s a solution.
Decomposing risk can take many forms. The basic approach is analyzing a portfolio based on its components. A basic risk-contribution profile via funds, for instance, is usually a good way to begin (as an example, see my discussion here). But a security based review merely scratches the surface. Knowing that one ETF in your strategy is the source of 60% of the portfolio’s return volatility, or that three funds represent 90% of vol, is useful information. But each conventionally designed fund is really a mix of factors, which means you have to go deeper to identify the real sources of risk and return. That’s where factor-based analysis (FBA) comes in.
Conceptually,  FBA is straightforward. Select a bunch of relevant risk factors and regress those factors against the return premiums on a portfolio’s holdings. In practice, however, the details can be tricky and so it’s best to have a clear idea of your goals before you start crunching the numbers.
The main issue is deciding what risk factors are relevant for the portfolio under scrutiny. This is where most of the heavy lifting will be done. For instance, are you focused mainly on macroeconomic factors, such as inflation, the business cycle, and so on? Alternatively, you can emphasize financial factors, such as value and growth factors for equities, and term and default factors for bonds. Or maybe it’s wise to combine macroeconomic and financial factors. Although there are some common-sense guidelines to follow, a wide range of customization is possible for selecting factors, depending on the portfolio and investment objective.
As a toy example, let’s decompose two highly rated (via Morningstar) multi-asset class mutual funds:  Vanguard STAR (VGSTX) and Leuthold Core Investment (LCORX) using data from 2000 forward. The Vanguard fund is relatively tame, skewing toward a quasi buy-and-hold strategy across a broad spectrum of global stocks and bonds. The Leuthold portfolio, by contrast, is far more active, favoring a tactical asset allocation methodology. Let’s see how the two funds compare when we run the numbers through a factor-analysis grinder.
