C urrents fall 2012 issue

Risk Factor Investing, Revealed Building Balanced Exposure to Rewarded by KAREN WITHAM s a traditional approach to investing Group. “They have now lost confidence I still working for you? Now may be the that a policy concentrated on a single time to consider optimizing your strategy source of returns can deliver the returns to help you reach your goals—whether they need. We are seeing more and more this means hitting return targets, investors contemplate changing from a lowering volatility, boosting funded single factor to a multi-factor ratios, or achieving other measures strategy as they seek new ways to meet of success. What we’re hearing from their long-term goals.” institutional investors is a need for improved performance but also for Bd uil ing Blocks for a greater predictability of returns, Vincent de Martel, CFA, is a especially in an environment of Better Portfolios senior investment strategist BlackRock’s research has identified anemic economic growth. in BlackRock’s Multi-Asset macroeconomic factors that influ- Strategies Group. In response to this new challenge, ence the returns of asset classes. The several years ago BlackRock started investment team uses this information researching how a strategy using risk to determine the optimal factors instead of asset classes could allocation with reference to the risk help investors achieve their desired factors, then translates that allocation outcomes. This approach, a cousin of into asset classes. In contrast, balanced strategies, aims to provide allocations of bonds and equities might more consistent returns than tradi- appear diversified in asset class terms, tional balanced portfolios while also but they may not be as diversified in limiting downside risk. terms.

“Institutional investors used to be able to “A risk-factor approach helps us better rely on the premium to achieve understand asset class returns and the their return targets,” says Vincent de correlation between assets so we can Philip Hodges, PhD, is a senior Martel, a senior investment strategist member of the research team build a more diversified portfolio that in BlackRock’s Multi-Asset Strategies in BlackRock’s Multi-Asset performs more consistently in different Strategies Group. environments,” says Philip Hodges, a senior member of BlackRock’s risk factor “The goal is to generate research team. “We seek to extract risk higher returns, less risk, premia and then recombine them into an optimal portfolio. The goal is to generate and more consistent higher returns, less risk, and more portfolio performance.” consistent portfolio performance.”

3 FALL 2012 Figure 1: Risk Factor Roll Call Asset classes are in reality a composite of exposures to these common risk factors

Inflation-Protected Bonds Real Rates

Nominal Bonds Real Rates Inflation Credit

Corporate Bonds Real Rates Inflation Credit

High Yield Bonds Real Rates Inflation Credit Liquidity

Emerging Bonds Real Rates Inflation Credit Liquidity Political

Global Equities Real Rates Inflation Economic Liquidity Political

So, what are these risk factors? We Liquidity: The risk associated with think of them as the fundamental 4 liquidity, which is reflected in the building blocks that make up an asset ability to trade an asset at low cost class (see Figure 1 for a breakdown and with little price impact. Even of the risks by asset class): typically liquid assets can be sensi- tive to illiquidity shocks. Real rates: The risk of bearing expo- 1 sure to real changes. Political: Risk that a sovereign All cash flow instruments are subject to 5 government will change capital this risk. Even investors who hold real market rules. bonds to maturity are subject to mark- Economic: Risks associated with to-market and opportunity-cost risk 6 uncertainty in economic growth. associated with real rate volatility. such as equities and real Inflation: The risk of bearing expo- estate that tend to generate poor returns 2 sure to changes in nominal prices. when the economy is weak should earn Any investment that offers a nominal a positive economic growth premium return rather than a real return should compared with assets such as high- offer an inflation premium to compen- quality government bonds, which are sate for this additional uncertainty. more likely to generate positive returns in bad economic environments. Credit: The risk of default. Typically 3 this is strongly linked to economic growth and also earns a positive premium over time.

C uRRENTS 4 R edefining “Diversified” BlackRock’s Multi-Asset Strategies Most portfolios have some exposure to Group. “However, by focusing on the all six macro risk factors. However, as one factors that drive returns rather than example, the typical pension’s exposures asset classes, we can build a more to these factors are skewed very high balanced portfolio of rewarded risk or very low, and may not reflect the exposures. Historically, each risk factor investor’s risk appetite or desire for has been rewarded at different times, return opportunity. Economic risk tends so this may be a more sensible approach to be heavily over-represented, while to portfolio construction.” (See Figure 3 typically there are just small slices of for a look back at rewarded risks in exposure to liquidity, credit and real different market environments from Thomas McFarren,CFA, rates risk. (See Figure 2 for a compari- 1982 to today.) is a member of the research son across various types of portfolios.) team in BlackRock’s Multi- For 2011, real-rates risk was by far the Asset Strategies Group. “A simple asset-class-based risk parity most highly rewarded at around 30% strategy is a step in the right direction as return. “Real interest rates are low at it reduces the over-representation of the moment, and our view is that we’re economic risk,” says Thomas McFarren, going to stay in a low-growth, low-rate a member of the research team in regime for some time,” says Hodges.

Figure 2: Balancing Act Why use risk factors for your strategic allocation? The average portfolio has some exposure to all six macro risk factors, but the weights can be skewed very high or very low, and may not reflect the investor’s risk appetite.

100

75

50

Risk Factor Exposure (%) Exposure Risk Factor 25

0 Typical pension 60/40 Risk parity (45/135) Risk factor portfolio

Liquidity Political Economic Credit Inflation Real rates

Aggregate top 200 defined benefit asset policy portfolio excludes assets classified in the survey by DB plans as ‘Alternatives’ or ‘Other.’ As of February 6, 2012. The 60/40 and 45/135 portfolios assume equities are invested in MSCI World and bonds are invested in Barclays US Aggregate. Sources: BlackRock and Pensions & Investments.

5 FALL 2012 “The interesting question is, what’s the returns across different asset types, “The interesting next regime? If we go into a rising-rate made intuitive sense and were accessible environment, then this model says that enough to enable an investor to gain or question is, what’s equity- correlation is going to exposure to it. the next regime?” increase. The portfolio that you thought For example, consider economic growth was well diversified will be less well risk, which tends to dominate most diversified, which is why it’s really investors’ portfolios. Our experts’ exam- important to look for other sources ination of this risk factor has led to some of risk premia.” noteworthy observations:

¾ Investors should consider diversifying R esearch Results globally to capture economic growth and the Road Ahead in as many regions as possible. It is Risk factor investing is not new, not necessary to forecast the fastest- but up to this point it primarily has growing economies to earn economic been concentrated in equity research. growth premia. Emerging applications include the use ¾ Economic risk is among the best- of risk factors for multi-asset investing, rewarded risk factors; however, and also for governance and setting a investors need a premium large strategic benchmark. enough to justify taking on additional The six factors highlighted here are the risk here when they’re already exposed result of an intensive selection process to it through their job or business. whereby our risk factor researchers ¾ Equities are predominantly exposed sought to identify the subset of factors to economic risk but they also are most relevant in explaining returns in a exposed to interest rate and inflation diversified multi-asset portfolio. During risk, even though the exposures to this filtering process, the goal was to these two factors have appeared low identify factors that reliably explained over the past decade.

Figure 3: Rewarded Risks Vary in Different Environments

Market Environment Years Factors Best Rewarded

Post-Inflation 1982–1991 Inflation

Bull Market 1992–1999 Credit, Economic, Liquidity

Tech Bubble Collapse 2000–2003 Real Rates and Liquidity

Bull Market 2004–2007 Economic and Political

Great 2008–2011 Real Rates

The Long Recovery 2012– ? ? ?

Source: BlackRock, August 2012.

C uRRENTS 6 D eploying Diversified Investors are looking for Risk Strategies something different, and Institutional investors are using risk- many have adopted risk based strategies in factor investment strategies. multiple ways, including as: Doing so is not quick, or easy. Among other things, imple- 1. A core holding, mentation takes strategic 2. An opportunistic allocation (e.g., for planning, organizational educational purposes in order to explore assessment and alignment the impact of this type of allocation, with boards; however, or as a holding on reserve for redeploy- the practical benefits and ment into tactical opportunities), insights that can result make 3. An intelligently balanced substitute it an approach worth consid- for a traditional balanced portfolio ering in today’s challenging (e.g., defined contribution), or and uncertain environment. ♦

4. Part of custom-built solutions.

DEEPER DIVE

To learn more about the risk factor approach to investing and BlackRock’s macro views on the markets and economy, consider reading:

“Risk Factor How-To: “Standing Still… “Balancing Act: Balancing act Currents introducing a risk factor approach to liability-driven investing. Quarterly Investment news from BlackRock SummeR 2012 by AlExiS pETrAkiS

s a strategy that could help plan to equities, leaving it exposed to the risk Standing Still ... But Still Standing sponsorsi increase their funded ratio of large economic slowdowns. And from and also reduce risk too good to be true? a surplus perspective, there is also an Why old-fashioned But Still Standing: Update of Our 2012 Outlook Introducing a risk Perhaps not. Adopting a risk factor under-appreciation for the other side of framework across all asset and liability the balance sheet —the liabilities. exposures can lead to a portfolio that BlackRock Investment Institute is built for positive outcomes over a “Numerous ‘perfect storms’ for pension July 2012 broad set of market environments. The plans over the past decade have taught framework should be not only more adroit us that in periods of stress, diversifica- at budgeting surplus risk, but also better tion often fails to deliver what was hoped for in our asset portfolios,” says Dan at selecting those risks that are apt to andy Hunt, FiA, CFA, is be properly rewarded. Ransenberg, a strategist with Black- a member of the BMACS Rock’s Multi-Asset Client Solutions team and leads Blackrock’s “Sometimes it’s a tough sell to get plan (BMACS) Group “Adding insult to injury, lDi capabilities in the asset allocation Update of Our 2012 factor approach Americas. Contact him at sponsors to adopt a new approach,” plummeting Treasury interest rates can andy.hunt@.com says Andy Hunt, head of BlackRock’s cause pension liabilities to skyrocket at BreaktHrougH liability-driven investment (LDI) the same time as the asset portfolio capabilities in the Americas. “What suffers. These two insights have spawned three common myths exposed we’re trying to demonstrate is that the risk parity and LDI strategies, respec- there is a better way forward—one that tively, that numerous sponsors are grows assets versus liabilities and does implementing today. We think the best diamonds in the rough not suffer the same painful setbacks way forward is to combine these that plans have repeatedly experienced strategies and to adopt a risk factor may thwart your Outlook,” BlackRock to liability-driven over the past decade or so.” approach toward LDI.” real estate for the risk- averse and yield-hungry UNiNteNded CoNSeqUeNCeS ldi FRom A RiSK FACtoR woRld risk factor how-to Plans have always believed in diversifi- A typical pension plan has significant cation, but are they approaching it the positive (long) exposure to economic wrong way? From an asset perspective risk and substantial negative (short) insider view of a typical plan (say, 60% equity and 40% exposure to . As we scientific active bonds), is assumed to be diversified across have witnessed, these exposures create asset classes. However, investors have problems for pension plans in economic investment goals,” top etf trends to watch Investment Institute, investing,” Currents begun to realize that capital diversifica- downturns, which catastrophically is just tion is not the same as risk diversification. when plan sponsors are most sensitive The typical 60–40 portfolio allocates and vulnerable. During these periods of greater than 90% of its asset risk budget tumult, economic risk is not rewarded, Currents magazine, July 2012. magazine, Fall 2011. Summer 2012.

Ask your account manager for a copy of these articles.

7 FALL 2012 C uRRENTS The information included in this material has been Investing involves risk, including possible loss of Published by BlackRock, Inc. taken from trade and other sources considered principal. Past performance does not guarantee reliable. No representation is made that this infor- future results. mation is complete and should not be relied upon In Canada, this material is intended for accredited Please direct story ideas, as such. Any opinions expressed in this material investors only. This material is provided for infor- reflect our judgment at this date and are subject to comments and questions to: mational purposes only and does not constitute a change. This material is not intended to provide Marcia Roitberg, editor solicitation or offering of shares or units of any investment advice. No part of this material may be Telephone 850-893-8586 fund or other security in any jurisdiction in which reproduced in any manner without the prior written such solicitation or offering is unlawful or to any Facsimile 415-618-1455 permission of BlackRock, Inc. [email protected] person to whom it is unlawful. The strategies referred to herein are among vari- For Institutional and Professional Clients in Latin ous investment strategies that are managed by America only. This material is solely for educational BlackRock, Inc., and its subsidiaries (together, purposes only and does not constitute an offer or a “BlackRock”) as part of its solicitation to sell or a solicitation of an offer to Find Currents on the web at and fiduciary services. Strategies may include col- buy any shares of any securities (nor shall any lective investment funds maintained by BlackRock blackrock.com/currents such securities be offered or sold to any person) in Institutional Trust Company, N.A., which are avail- any jurisdiction within Latin America in which an able only to certain qualified employee benefit offer, solicitation, purchase or sale would be un- To subscribe, visit plans and governmental plans and not offered to lawful under the securities law of that jurisdiction. the general public. Accordingly, prospectuses are blackrock.com/subscribe/currents No information discussed herein can be provided not required and prices are not available in local to the general public in Latin America. publications. To obtain pricing information, please contact a defined contribution strategist. Strategies ©2012 BlackRock, Inc. All rights reserved. maintained by BlackRock are not insured by the BLK-0380 5275_R4_v01AG_9/12 Federal Deposit Insurance Corporation and are not guaranteed by BlackRock or its affiliates. For institutional use only— not for public distribution blackrock, Inc. 400 Howard Street San Francisco, CA 94105 blackrock.com

RISK FACTOR VALUATIONS All asset classes share exposures to common risk factors. When one or several factors move out of their long-term normal valuation range, the asset classes that are exposed to them are faced with greater than normal upside or downside risk. For maximum diversification, investors should hold a balanced exposure to all risk factors that are expected to deliver positive returns in the long run. Here we present one way of looking at the potential returns of six risk factors and compare the risk premia for June 2012 vs. June 2011 to show how (and if) things have changed.

Extremely At fair long- Extremely expensive (low term value cheap (high expected returns) expected returns) 0 0 0 –1 1 –1 1 –1 1

–2 2 –2 2 –2 2

–3 3 –3 3 –3 3 Real Rates Inflation Credit

0 0 0 –1 1 –1 1 –1 1

–2 2 –2 2 –2 2

–3 3 –3 3 –3 3 Economic Political Liquidity

June 2011 June 2012

Source: BlackRock analysis, as of June 30, 2012.