A series of global financial crises over the past 15 years have made clear that traditional methods of portfolio risk management are no longer up to the task. Investors employing traditional asset allocation, such as the mechanical apportioning of portfolios between stocks and bonds, and the geographic distribution of funds between multiple markets, have found that when markets are hit by extreme volatility, the diversification enjoyed in risk-engaging markets disappears. Massive covariance ensues as investors flee to quality.
Investors digging deeper to uncover the true drivers of contemporary bond and equity returns have found that strategies focusing on themes and factors such as size, momentum and particularly value deliver reduced correlation. Investors using thematic/factor strategies can derive additional risk protection through the use of market- and sector-neutral investing techniques because valuable information can be extracted from rising as well as falling markets.
Diversification and Crisis
In this paper, we set up the motivation for structuring an investment program in terms of some common well-documented investment themes. Consideration of stock market investment arises because of the equity risk premium (which consists of the excess return that stock market investment provides over the risk-free rate). We outline themes that challenge some standard workhorse models of asset pricing such as the capital asset pricing model (CAPM).
Additionally, we focus on the value investment theme. Specifically, we show that a simplistic investment program that, rather than investing in the traditional 60/40 percent split between stocks and bonds, allocates 10 percent from each to the value theme, is a superior alternative on a number of grounds. The purpose of this paper is to scratch the surface of a new approach to asset allocation and to suggest some complementary methods that can be used when allocating assets.1 Finally, we show that adding market- and sector-neutral conditions to a value investment theme are critical components to building uncorrelated returns that can complement a core investment portfolio.
Thematic Investing, Horse Racing And Finance
Given the changing nature of contemporary financial markets—and the extraordinary speed with which efficient market structures transmit negative investor sentiment and contagion—it is clear that new investment themes have emerged. The global financial crisis has made clear that equity and bond markets are evolving, and to succeed, investors need to adapt to this changing environment. Because of this, it is critical that investors set aside traditional diversification and risk management tools and dig deeper to discern more precisely the true drivers of equity and fixed-income market returns.
Thematic investing seeks to explore a new means of understanding markets by giving investors insight into investing as a result of studying the properties of securities with similar characteristics. To illustrate this new approach to understanding securities characteristics, we might consider two analogies: one from horse racing and another from the world of stocks.
Horse breeding has become a large commercial enterprise predicated on the belief that the speed of a horse is an inherited characteristic. Investors paying top dollar for the foals of champions obviously believe that the racing success of a given horse is in large measure a function of genes inherited from their winning parents. But racing success is not determined solely by birthright. In addition to the genetic heritage of a horse, there are several external factors, such as diet, training and even which jockey is riding the horse, that all conspire to define a horse’s speed.
The same holds true in the financial world. Positive returns are a desirable trait for investments, just as speed is a desirable trait for horses. But positive returns, like racing speed, are subject to several common influences that define the expected returns of various investments. For example, in the 1970s, several academics came to recognize that assets with similar characteristics tend to behave in a uniform manner—a notion that was first captured by the arbitrage pricing theory (APT) developed by economist Stephen Ross in 1976.2 The APT holds that security and portfolio expected returns are linearly related to the expected returns of an unknown number of underlying systematic common influences/themes. At the core of the APT is the notion that the price of a security is driven by a number of common influences/themes, and these can be divided into two distinct groups: macro themes; and company specific themes.
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