Traditional asset allocation gives a limited understanding of the impact of market forces on portfolio risks and returns. J.P. Morgan Asset Management uses a new method of examining the driving factors of return and volatility.

On the surface, the standard asset class buckets of equity, fixed income, alternatives, and cash seem to differentiate major investment types and the broad risks associated with them. But many asset classes are affected by the same risk drivers and their risks overlap. Therefore, they aren’t as distinct as they seem, and risk exposures may be greater than they appear.

For example, equity long-biased hedge fund strategies have similar exposures to a traditional long-only equity portfolio. Real estate and hard assets, such as gold or timberland, are affected by the same overall “real asset” factor.

The result of using factor risk management is greater transparency and insight. In contrast to a standard allocation profile in one example indicating a 38% portfolio-wide equity risk, the factor profile model tallied a 51% total portfolio allocation to equity risk.

Factor analysis is an exciting and practical new approach to risk management. It provides greater transparency and insight, and presents portfolio managers and investment policymakers with new tools so they may manage it more accurately.