RT Journal Article SR Electronic T1 Portfolio Optimization with Active, Passive, and Factors: Removing the Ad Hoc Step JF The Journal of Portfolio Management FD Institutional Investor Journals SP jpm.2020.1.127 DO 10.3905/jpm.2020.1.127 A1 Roger Aliaga-Diaz A1 Giulio Renzi-Ricci A1 Ankul Daga A1 Harshdeep Ahluwalia YR 2020 UL https://pm-research.com/content/early/2020/01/14/jpm.2020.1.127.abstract AB In this article, the authors propose a comprehensive framework for simultaneously allocating assets among active, passive, and factor investments while accounting for the uncertainty in each of the sources of return and investor risk preferences toward them. The proposed model enables investors to overcome the often adopted approach of first deciding the asset allocation and subsequently allocating across active and factor strategies. The authors also highlight some business applications of the adopted approach, such as the construction of factor tilted portfolios and the substitution of low-cost factor strategies for higher cost active portfolios.TOPICS: Analysis of individual factors/risk premia, factor-based models, portfolio theory, portfolio constructionKey Findings• Using an expected utility optimization model, the authors can simultaneously allocate assets among active, passive, and factor investments while accounting for investor risk preferences.• Optimal asset allocation responds to changes in the level of risk aversion across systematic, alpha, and factor risk; expected factor-adjusted alpha levels; tracking errors; and predicted factor premiums.• This approach allows for full customization of portfolios and brings to light many decisions that investors would otherwise make subconsciously.