Improved Risk Reporting with Factor-Based Diversification Measures

Improved Risk Reporting with Factor-Based Diversification Measures — February 2014

Foreword

protection against market shocks. Here too, the results show that risk allocation and risk-based weighting make sense when constructing well-diversified indices. I would like to thank Lionel Martellini and his co-authors, Tiffanie Carli and Romain Deguest, for the quality of this path-breaking publication. We would also like to extend our warmest thanks to our partners at CACEIS for their insights into the issues discussed and their commitment to the research chair.

The present publication, “Improved Risk Reporting with Factor-Based Diversification Measures,” is drawn from the CACEIS research chair on “New Frontiers in Risk Assessment and Performance Reporting” at EDHEC-Risk Institute. This chair looks at improved risk reporting, integrating the shift from asset allocation to factor allocation, improved geographic segmentation for equity investing, and improved risk measurement for diversified equity portfolios. Before the financial crisis, pension funds were insufficiently diversified, with concentration in a small number of asset categories. Since the crisis of 2007, there has been a genuine trend towards investment in new asset classes and categories in order to diversify, but that does not mean that the diversification is effective. As we see in the current publication, what is important is the “effective number of bets” (ENB) in a portfolio, not the effective number of constituents (ENC). Only ENB delivers superior performance. Increasing the number of asset classes or categories without taking the inter-relations between their risks into account does not provide any real gain in terms of performance. Investors are right to wonder about the excessive concentration of their cap-weighted benchmarks, because the excessive concentration has a negative impact both on performance and on the capacity to weather bear markets. However they should be even more concerned about the real risk concentration of these indices. ENB is clearly a more statistically significant indicator that ENC in appreciating the quality of portfolio diversification and

We wish you a useful and informative read.

Noël Amenc Professor of Finance Director of EDHEC-Risk Institute

3

An EDHEC-Risk Institute Publication