Asset Allocation and Factor Investing: An Integrated Approach

Asset allocation and factor investing are often seen as competing approaches to portfolio construction. Historically, most investors composed portfolios from broad asset classes, but now a growing constituency of investors is looking to factors as the building blocks for forming portfolios.

Those who choose to build portfolios from asset classes argue that they are easy to observe and are directly investable. Factors, by contrast, are not always readily observable, nor are they directly investable. Investors must identify combinations of assets that best track the behavior of factors, and because the mapping functions between assets and factors change through time, investors who choose to allocate to factors are exposed to an additional source of uncertainty beyond the uncertainty of the factor performance.

Investors who prefer to allocate to factors argue that asset classes are defined arbitrarily and do not capture the fundamental determinants of performance as effectively as factors do. In addition, some investors prefer to invest in factors because they believe that factors carry risk premiums that are not directly available from asset classes.

We propose a compromise. We argue that investors should continue to use asset classes as the building blocks for forming portfolios,¹ but they should combine them in a way that balances their expected return and risk with adherence to a preferred factor profile. This approach preserves the benefit of investing in observable and directly accessible units, while enabling investors to capture preferred factor exposures.

METHODOLOGY

The traditional approach for constructing portfolios, which was given to us by Harry Markowitz [1952], is to maximize expected utility as defined in Equation 1.

1

[Figure omitted. See PDF]

In Equation (1), E(U) equals expected utility, μ_p equals portfolio expected return, λ_RA equals risk aversion, and [Figure omitted. See PDF] equals portfolio variance. To proceed, we estimate the expected returns for all of the asset classes under consideration as well as the covariances between every pair of asset classes. We then vary the asset class weights for a given level of risk aversion so as to maximize expected utility.

In addition to the expected return and risk characteristics of these asset classes, we may have preferences for certain factor exposures. We could therefore define a factor profile as a weighted average of...