The Role of Factors in Asset Allocation

For many decades, asset classes have been the main building blocks for constructing portfolios, and, appropriately, they still are. However, in recent years investors increasingly have considered factors as an alternative to asset classes. In some cases, the motivation to substitute factors for asset classes is misguided, but factors can serve a valuable role in portfolio composition. The author discusses how investors should consider factors when constructing portfolios and, in doing so, exposes their misuse as well as their proper role in asset allocation. TOPICS:Factor-based models, portfolio construction, performance measurement Key Findings ▪ Investors should allocate to asset classes instead of factors for strategic asset allocation. ▪ Investors should allocate to factors to improve performance. ▪ Investors can have it both ways by allocating to asset classes, but in a way that tilts toward preferred factor exposures.