The same applies when investing. First, the individual risk appetite and risk capacity must be determined. Risk factors, such as interest rate, equity and illiquidity risk, serve as the basis. This lays the foundation for an optimal investment plan. Analogies to sport apply here too. Just as the optimal training plan varies depending on the type of sport and age of the athlete, the optimal investment plan should also be tailored to the investor. A younger athlete in an explosive sport places more emphasis on speed, which may correspond to a higher equity or illiquidity risk when investing. Like a training plan with exercises as a bundle of fundamentals to achieve a sporting goal, the SAA and its asset classes are a bundle of optimal risk factors for the targeted investment goal.
What are the fundamentals of each investment strategy?
We analysed the investment returns of typical multi-asset strategies for the fundamental components. This revealed that many asset classes depend on the same drivers. What's clear is that 85% of the risk of an investment strategy can be explained in three factors; and six factors account for 95%. Based on a statistical analysis, we have determined the fundamentals that can explain as much as possible of the risk of an investment strategy and the individual asset classes, with as few factors as possible and a low correlation. For example, we abstained from a credit premium because it is already covered by the equity market and illiquidity premium.
It is evident that each asset class can be characterised by the following, deeply correlated risk factors:
- Swiss interest rate risk
- Global interest rate risk
- Swiss equity market risk
- Global equity market risk
- Illiquidity risk
- Emerging markets risk
- Real estate risk
- Commodity risk
- Gold risk
We model the foreign currency risk with the effective currency allocation of the respective asset class. Despite the limitation to these nine risk factors and the foreign currency risk, more than 98% of the risk of a typical investment strategy can be explained. If we have these risk factors under control, we can create the optimal investment plan.
How can we see asset classes as a mix of fundamentals?
As with physical exercise, where stretching the back leg muscles, for example, is associated with promoting a fundamental aspect (mobility), there are asset classes that only have to take one risk factor into account. One example of this is the broad Swiss equity market, which is entirely subject to the Swiss equity risk factor. However, if you combine stretching the leg muscles with the standing scale on one leg, for example, the ability to coordinate is added as a second fundamental aspect. An analogy to this is the separate consideration of Swiss small and mid caps. In addition to Swiss equity risk, they also include a premium for illiquidity.
In general, it can be stated that the more complex the training exercise or asset class, the more fundamentals or risk factors are involved. For instance, European corporate bonds are not only dependent on global interest rate risk, but also have a sensitivity to illiquidity risk and global equity risk due to the additional credit risk. They are also exposed to a foreign currency risk in euros.
Allocation of risk factors to asset classes