Understanding Investing

Asset Class Diversification Is Not the Same as Risk Factor Diversification

Learn why identifying underlying risk factors is critical even in highly diversified portfolios.

Even highly diversified target-date funds may not adequately cushion market volatility. Understanding the underlying risk factors that many asset classes share can help investors create a more efficient, risk-managed glide path.

What these charts show
Target-date portfolios may contain unintentional risk. The market average glide path shown here is broadly diversified across asset classes, but in fact has a very concentrated exposure to underlying equity risk. 

What it means for investors
Target-date solutions need to take an allocation approach that looks beyond asset class labels and focuses instead on risk factors – the underlying risk exposures that ultimately drive investment returns.

Asset allocation pie chart Asset allocation pie chart
Source: PIMCO, MarketGlide as of 30 June 2013. Charts represent the market average glide path 10 years into retirement.
*Other factors include idiosyncratic (specific) country and muni factors.

Risk allocation pie chart Risk allocation pie chart
Source: PIMCO, MarketGlide as of 30 June 2013. Charts represent the market average glide path 10 years into retirement.
*Other factors include idiosyncratic (specific) country and muni factors.

What this chart shows
Risk factor diversification: A more efficient allocation approach Different asset classes often share the same underlying risk factors, which explains the majority of their returns. The chart shows the degree of various risk factor exposure across asset classes. For example, broad equity risk factors are present in a wide range of investments. 

What it means for investors
A truly diversified target-date strategy should look beyond asset class labels – first identifying risks that deliver the best return potential, and then selecting a mix of asset classes that provide the most efficient exposure to those risks. This allows investors to avoid risk factors believed to be overvalued or carrying excessive downside potential.

Asset Class Risk Factors table

Source: PIMCO. Spread duration refers to the price sensitivity of a specific sector or asset class to a 100 basis point (1%) movement in its spread relative to Treasuries.

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The Cost of Cash ‘Safety’

Unlike term deposits, the risk of bonds is often inversely correlated to equity risk. A portfolio comprising 60% equities/40% bonds had a higher annual return and lower volatility over the last 10 years than a portfolio of 60% equities/40% cash.

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Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information is contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your financial advisor, by visiting pimco.com/investments or by calling 888.87.PIMCO. Please read them carefully before you invest or send money.

A word about risk: Bonds and bond funds with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise. Target-date funds invest in other funds and performance is subject to underlying investment weightings, which will vary. The cost of investing in a fund that invests in other funds will generally be higher than the cost of investing in a fund that invests directly in individual stocks and bonds. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk including market, political, regulatory, and natural conditions,
and may not be suitable for all investors. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Non-diversified funds may concentrate assets in a smaller number of issuers than diversified funds.