Building indices using risk components.
An asset owner may choose to combine the risk-based asset allocation described in the first example with the single-asset risk-based benchmarks shown in the second example. Consider an asset owner who allocates to two managers, one specialising in fixed income and one in equity. The owner may allocate using the benchmark we obtained in Example 1, which combines equity and fixed income based on their relative risk, while being agnostic about their relative value.
Furthermore, he can define the benchmarks associated with the two managers following a risk-centric approach similar to Example 2. For equity, he may use an industry-based risk combination, whereby industries that are more risky get a lower weight. For fixed income, he may break down exposure by asset type. A schematic of this process is presented in Figure 4. This example showcases the scalability and flexibility of this risk-based approach.
KEY ISSUES IN INDEX DESIGN
The flexibility of risk-based index construction comes at a price: we must make many choices from benchmark structure ("should we break down corporate risk according to ratings or along industry characteristics?") to construction method details ("how should we account for correlations?") to the risk forecasting model ("should we use a 12-month window or should we use three months of daily data?"). To make appropriate choices we must understand what role these choices play in the final benchmark. In this section we will explore some key issues in risk-weighted index design.
Asset Classes Or Risk Factors As Building Blocks
The first choice to be made concerns the breakdown of the investable universe. Let's take the case of an asset owner creating a benchmark for a fixed-income manager. The question is what building blocks should be used, and should they be based on various asset classes (eg, Treasuries, agencies, securitised, or corporates), or should they be based on risk types (eg, rates, credit spreads, securitised spreads)?
The choice has major consequences for a benchmark: for example the returns of investment grade corporates are dominated by interest rate risk, making them highly correlated with Treasuries. To achieve efficient diversification, building blocks should be as unrelated as possible from a risk perspective. Because corporates and Treasuries exhibit similar behaviour, the asset owner may find it undesirable to have them both as building blocks in the benchmark. However, corporates do have a component that is different from Treasuries, the credit spread return, and it may make sense to isolate it as a separate building block and then to combine the common interest rate risk of Treasuries and corporates into one block (see Figure 5).