Asset Allocation

CHAPTER 16Asset Allocation Versus Factor Investing

THE CHALLENGE

Many investors think of a portfolio as a composition of factor exposures, yet the vehicles available for investment are financial securities or aggregations of them such as asset classes. Moreover, investment in a collection of securities that is designed to mimic factor behavior introduces mapping error, which increases portfolio risk. This chapter shows how to construct portfolios of asset classes that at the same time reflect an investor's preferences for specific factor exposures.

Investors typically construct portfolios from asset classes because asset classes are easy to observe and 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.

Nevertheless, some investors prefer to allocate to factors because they believe asset classes are defined arbitrarily and do not capture the fundamental determinants of performance as directly as factors do. Also, some factors carry risk premiums that are not available from asset classes.

In this chapter, we show that investors can have it both ways. We propose that investors use asset classes as the building ...