Building a better factor risk model 

Solutions must have a standardized feel yet be nimble enough to reflect ongoing industry changes and align with a manager's particular investment style. At SimCorp, for instance, clients can choose among the Axioma fundamental and statistical medium- and short-horizon global, regional and single-country factor risk models, as well as a macroeconomic risk model. This flexibility provides a more in-depth and accurate assessment of portfolio risk.

Fine tuning factor risk model methodologies

Risk models can be fine-tuned by making improvements to the estimation universe. For instance, stock data that is missing or incomplete due to illiquid returns or insufficient performance history can easily skew portfolio analysis, resulting in factor return errors. To remedy this, we can exclude IPOs or other new issues from the estimation universe, along with any stock lacking a substantive record of returns for at least the past eight months.

But is it necessary to address every one of these illiquid "outliers"? There are certain circumstances – say, when working with frontier markets, depositary receipts (ADRs) as well as other foreign issues – where it becomes necessary to make some accommodations for illiquidity. One way to achieve this is through a proxy return component, which allows investors to generate synthetic returns for the purpose of estimating IPOs or illiquid asset performance, as well as in other situations where actual returns aren't fully available.

Configuring factor risk models to account for other nuances is also key. For example, the global version of the Axioma equity risk model sports a proprietary "returns-timing" adjustment feature that makes allowances for different global market close times. So, if the Hong Kong trading day ends, and then the US markets decline during its trading day, then the factor risk model should reflect the latest market activity and adjust the risk of the Hong Kong-based securities. Axioma factor risk models capture this nuance, which results in a more accurate risk assessment for global portfolios that trade intra day.

Focus on risk factors

Regularly updating the list of risk factors is also paramount, particularly as newer markets and strategies continue to emerge. Our style factors include separate value and earnings yield factors to account for the interplay between the two, as well as dividend yield and profitability factors. We also have a leverage factor that includes a debt-to-equity ratio (in addition to debt to assets). This allows users to consider the impact of leverage on the financial sector (in contrast to non-financial industries). Similarly, adding a profitability component for factors like gross margins, return on equity and cash flow to assets gives quality or profitability-based managers a reliable metric with which to gauge ongoing fund performance and risk attribution.

Risk factor differentiation

Portfolio managers may also want to avoid the possibility of using risk factors and strategies that are too similar to peers. We have solutions that help our clients create factors and models that can be customized to match their preferred investment style, which results in more intuitive performance attribution and a more accurate risk-return profile. For example, we offer a diverse Factor Library that gives clients the tools to analyze asset and portfolio sensitivities to an additional set of fundamental and macro factors, as well as a Risk Model Machine, which allows users to easily build fully customized risk models.

Comprehensive coverage with factor based risk models 

The speed and sophistication of today's marketplace demands risk solutions that are versatile enough to cover a wide range of fund approaches, including actively managed, long-short, index-tracking and more, while allowing managers the flexibility to align risk exposures with their specific objectives.

With the global markets constantly in flux, now more than ever it is crucial that factor risk models incorporate the most up-to-date research and are aligned and customized to the manager's investment strategy. Partnering with an expert in the field can go a long way towards ensuring that these objectives are met.

Learn more about the Axioma factor risk models or contact us below.