Factor Risk Model and Portfolio Construction with a Focus
on Surplus Risk

Abstract

We examine asset classes through a single-factor lens, using a factor risk model that enhances the transparency and consistency of portfolio construction and risk management. We show how risk factors can be used as building blocks for diversification and apply factor analysis to asset-class bucketing, asset allocation, manager evaluation, and risk management. We contrast the intuitive features of a traditional approach with our hybrid approach, which calculates the risk decomposition based on three drivers including factor loading, stand-alone risk, and correlation. We provide immediate insight as to how the impact to total risk and surplus risk is caused by various dimensions and sliced buckets, and we show where to further modify and manage risk exposure through correlation decomposition. Finally, we provide risk-analysis cases, using the implemented factor risk model.

TOPICS: Portfolio construction, factor-based models, risk management