Factor Based Asset Allocation

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.

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