Factor Allocation Model: Integrating Factor Models and Strategies into the Asset Allocation Process

Abstract

Factors are the underlying forces that drive portfolio risk and performance over different investment horizons. In this article, first the author reviews the theoretical foundations and practical applications of factor models. The author then discusses the integration of factors into different types of investment strategies. He concludes with a discussion of how factor models and strategies enable investors to manage total portfolio risk and capture risk premiums through the asset allocation process.

TOPICS: Factor-based models, portfolio construction, risk management, performance measurement

Key Findings

• ▪ Factor models empower investors to understand and manage the sources of portfolio risk.

• ▪ Factor strategies reflect factors, offering investors the ability to capture factor premiums.

• ▪ In factor allocation, factors replace asset classes as the drivers of asset allocation decisions.