Although not for novice investors, Andrew Ang’s new book, “Asset Management: A Systematic Approach to Factor Investing,” represents a comprehensive, clearly written and accessible review of the latest thinking in modern financial theory.
It provides some important lessons that investors can learn and implement in constructing well-diversified portfolios. I thought it worth sharing some of the most noteworthy points that Ang—a professor at the Columbia School of Business and an advisor to the Norwegian sovereign wealth fund, the largest such fund in the world—covers in depth.
In his chapter on mean-variance investing, Ang observes that it’s all about diversification, which he defines as the process of exploiting the interaction assets have with each other to build more efficient portfolios. Ang examines several diversification strategies—including mean variance, risk parity, equal weighted and market weight—and provides explanations of the pros and cons of each.
Given the popularity of risk-parity strategies, I thought it was worth sharing this warning. Ang cautions that sample results for risk-parity strategies look especially good because of the heavy weight such strategies put on bonds, and interest rates have been trending downward for more than 30 years now. This accounts for a large amount of the strategy’s outperformance. He warns that risk parity requires estimates of volatility, and that it overweights assets with low past volatility.
Past volatilities tend to be low precisely when today’s prices are high. Presently, bond yields are at record low levels, and current high prices could end up making bonds risky investments. Ang warns that risk-parity strategies are procyclical because they ignore valuations.
Focusing On Risk
In the chapter on factor theory, Ang explains: “Assets have risk premiums not because the assets themselves earn risk premiums; assets are bundles of factor risks, and it is the exposure to underlying factor risks that earn risk premiums.” He added that these factor risks tend to show up in bad times, such as during the financial crisis of 2008.
Thus, Ang suggests investors change the way they think about diversification, moving away from asset-class allocation to factor allocation. He writes: “Investing right requires looking through asset class labels to understand the factor content.” That’s the same approach advocated by Antti Ilmanen in his excellent book, “Expected Returns.”
In other words, assets are just bundles of factors, and different investors have different optimal exposures to different sets of risk factors.