For many decades, investors have focused on asset classes as the main building blocks for constructing portfolios. The analysis of common factors (such as value and size) affecting asset risk and return has brought the approach of factor investing (see earlier article). Leading institutional investors apply factor models to their investment process, but does this approach make sense for a private investor?
Recently, institutional investors have increasingly considered factors as an alternative to asset classes. Factors would drive asset allocation decisions while asset classes and individual securities become mere implementation vehicles. In its extreme application, factors would even even replace asset classes as building blocks for forming portfolios.
The application of factors as building blocks for forming portfolios requires an extensive use of derivatives and poses several challenges to individual investors: A strategy based exclusively on factors will inevitably have structural biases, which is detrimental to a long-term balanced portfolio. Even after the common drivers are identified, investors face several challenges in building factor models as actual data do not capture factors in a straightforward way. Using factors instead of asset classes would be riskier and more costly.* Investors should be able to build their portfolios without paying excessive transaction costs, increasing liquidity risk or entering complex derivative transactions.
The most important distinction between factors and asset classes is that factors are not stable and directly investable like asset classes. Factors, therefore, introduce both additional risk and additional cost because they must be continually rebalanced without cost-effective vehicles.
Retail investors should use asset classes to represent their strategic portfolio weights, even if factors can improve portfolio understanding and performance. Despite their limitation to substitute for asset classes, factors have a valuable role in portfolio composition. They will probably remain a key element of modern investment in order to manage total portfolio risk and capture risk premiums through the asset allocation process.
In summary, investors should still be allocating to asset classes, but in a way that reflect their preferred factor exposures. While most private investors should start by following a passive approach and should use asset classes as the building blocks to form portfolios, factors can offer attractive opportunities to enhance performance of more advanced investors.
* Note for advanced investors: The proposal to expand the objective function to maximize return and minimize risk and deviation from a preferred factor profile is a fair attempt to tackle this issue but adds complexity.
Sources: Factor Allocation Model: Integrating Factor Models and Strategies into the Asset Allocation Process, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Dimitris Melas The Role of Factors in Asset Allocation, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Mark Kritzman Factor Allocation as Reverse Attribution, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Joseph Simonian Macro Factor Model: Application to Liquid Private Portfolios, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Scott Gladstone, Ananth Madhavan, Anita Rana, and Andrew Ang