In case of emergency activate the factors control!

The once-in-a-lifetime change in the USA’s political and economic doctrine has left investors quite puzzled. In an uncertain world, it is even more relevant to structure your portfolio using all the levers of diversification, including the usually neglected factors control.

The USA administration’s tentative, unconventional measures combined with uninspiring communication have led investors to question the US financial market exceptionalism. Investors with substantial exposure to the US equity market should ask if proper risk management requires a more balanced allocation to the US dollar, as well as to the US equity and debt markets. These are the three most liquid markets when it comes to currency, bonds, and equities. This means also that, no matter how involved you are in US investments, what happens in the US will impact the entire financial market via secondary effects on the liquidity of the entire financial system. Witnessing a once in a lifetime change of political and economic doctrine, investors face higher degree of uncertainty. Accordingly they need to strive for the maximum degree of diversification out of their strategic investment process.

Let s look at equity investments: the US equity market represents about 70% of the developed public markets and 65% of the all-country public market, as measured by the MSCI index. The US equity index is characterized by strong concentration in certain sectors and individual stocks. The US equity index is trading at historically high multiples, and comparisons with other markets reveal substantial gaps between valuation multiples. High level of debt, trade and budget deficit weigh on the USD. Given the fiscal, political, social, and geopolitical situation, the degree of fragility is quite high.

A relatively easy way to diversify is allocating geographically and by sector. Moving a step ahead and striving for more effective diversification, investors should actively address the fundamental characteristics of the investments, namely the factors and style profile. The latter is a less directly readable characteristic of a portfolio. Building balanced equity strategies requires control and active positioning with respect to the underlying characteristics of the portfolio, the factors like Value, Profitability, Low Vola, Growth, Size etc…. Addressing this issue is an important feature for stabilizing the portfolio across different market scenarios and is quite helpful for all active strategies that go beyond mechanical market cap benchmark replication.

If you invest by replicating a benchmark, you accept country, sector and single stock concentration risk. At the same time blindly and unknowingly you are taking factors exposure, which might not necessarily be a balanced one. You can enhance the level of diversification by addressing concentration (including factors) risks with small increase in tracking error. Alternatively, you can adopt a more balanced benchmark and monitor and measure performance against it.

In an uncertain world it is even more relevant to structure portfolios using all the levers of diversification. Proper diversification requires going beyond the allocation dimension, such as nominal exposure toward standard asset classes. It is also important to look into and select and control the desired underlying drivers of performance, derived from fundamentals and or price dynamics.

At QuantArea together with our clients we design the investment solution by addressing the allocation decision and selecting a deliberate position with respect to the portfolio fundamental drivers. Thanks to an active positioning and control on the targeted (desired) and non targeted (residual) factors, the improvement in the risk and performance measures is quite sensible.

Carmine Orlacchio, 18.06.2025