A Practitioner's Guide to Asset Allocation

CHAPTER 6Factors

FALLACY: FACTORS OFFER SUPERIOR DIVERSIFICATION AND NOISE REDUCTION

In this chapter, we address two common fallacies about factors. The first fallacy is the notion that portfolios composed of factors are better diversified, and therefore more efficient, than portfolios composed of asset classes. This claim might seem plausible because correlations among factors tend to be lower than correlations among asset classes. But this comparison is specious, as we soon demonstrate.

The second fallacy is the notion that investors reduce noise more effectively by consolidating securities into factors as opposed to asset classes. In fact, we show the opposite to be true; factors are noisier than asset classes, which we explain and illustrate later on.

WHAT IS A FACTOR?

First, let's distinguish between factors and asset classes. They must be different, otherwise the premise of factor investing would be redundant. Perhaps the most important characteristics that distinguish asset classes from factors are that asset classes have stable composition and are directly investable. (See Chapter 1 for more about the characteristics of asset classes.) Factors, by contrast, are labels that reflect exposure to a source of risk and are not directly investable. Moreover, the composition of the collection of assets designed to replicate them is unstable. Investors must periodically rebalance the replicating assets.

The term “factor” is used in a variety of ways, including:

• A simple combination ...