An alternative approach used by some practitioners is to move away from an opportunity set of asset classes to an opportunity set consisting of investment factors.
In factor-based asset allocation, the factors in question are typically similar to the fundamental (or structural) factors in widely used multi-factor investment models. Factors are typically based on observed market premiums and anomalies. In addition to the all-important market (equity) exposure, typical factors used in asset allocation include size, valuation, momentum, liquidity, duration (term), credit, and volatility.
The factors themselves are zero-dollar investment portfolios that are long the better performing attribute and short the underperforming attribute. For example, there are three factors in the Fama-French model:
- A zero-dollar portfolio long in small stocks and short in large stocks (the size factor).
- A zero-dollar portfolio long in value (high book-to-market) stocks and short growth (low book-to-market) stocks (the value-growth factor).
- The market portfolio.