A Factor Approach to Asset Allocation

Abstract

The typical asset allocation decision focuses on gaining exposure to systematic market risks such as equity, interest rate, and credit risk. Investors also often explicitly manage their exposure to firm-specific characteristics like size, book-to-market, or momentum. For a global portfolio, we can add another category of exposures not correlated with systematic market risks and firm-specific characteristics: global market factors that explain the cross-section of returns across individual equity, fixed-income, and currency markets. Portfolios constructed to include exposures to each of these three categories of risk and return seem to be more efficient at producing diversified returns than those limited to just systematic market risks. Using this factor-based approach to asset allocation results in optimal portfolios with significantly less exposure to equity market risk than the typical institutional portfolio generated using the traditional asset allocation approach.