Using Risk Factors in Asset Allocation vs. Traditional Asset Class–Based Approaches

Introduction and Core Concepts

It might sound a little surprising at first, but focusing on broad asset classes—like just labeling things “Equity,” “Fixed Income,” “Real Estate,” and so on—can hide some of the real drivers behind your portfolio’s performance. Over time, portfolio managers have realized that certain factors, such as “value,” “momentum,” “credit,” and “liquidity,” often explain the ups and downs in their investments even better than the asset class labels we’ve used for decades.

There’s a classic story I recall: A friend of mine managed a so-called “diversified” portfolio, half in global equities and half in global bonds. She thought, “Hey, good enough.” But as it turns out, nearly all of her equity holdings were leaning toward “growth” stocks, and her bond allocation was heavily tilted toward lower credit-rated issuers in emerging markets. Both of those exposures ended up having a common risk element—essentially a pro-cyclical tilt that struggled when global market sentiment shifted. If only she had carefully examined the underlying factor exposures, she might have realized her portfolio wasn’t all that balanced after all.

This is where factor-based investing can really up your game. By peeling back the layers of broad asset classes and looking at the fundamental attributes that drive returns, you can see your portfolio’s true risk profile and possibly improve diversification. In what follows, we’ll explore how this factor-based approach compares to the traditional asset class approach. We’ll also discuss implementation, challenges, best practices, and a bit of exam-relevant guidance for those of you preparing for the CFA Level III exam.

Why Factor-Based Investing?

A factor-based approach involves dissecting an investment portfolio into the fundamental drivers of risk and potential return. While we typically say “I’ve got 40% in equities, 40% in bonds, 10% in real estate, and 10% in alternatives,” a factor perspective would dig deeper to discover, for instance, that your equities have a heavy “growth” orientation, your bonds are mostly “credit” exposures, and your alternatives share a big “liquidity” premium risk.

The main factors commonly discussed include:

• Value: Strategy that tilts toward lower-priced securities relative to their fundamentals (e.g., low price-to-earnings or price-to-book multiples).
• Growth: Strategy focusing on companies expected to grow quickly, trading at higher valuations relative to their current fundamentals.
• Momentum: Strategy that favors securities with strong recent performance, expecting that trend to continue (at least over a shorter term).
• Size: Strategy that differentiates between large-cap versus small-cap companies (smaller firms have historically had periods of outperformance due to higher risk/reward potential).
• Quality: Strategy emphasizing profitable, stable companies, often identified via metrics like return on equity or low debt usage.
• Credit: Strategy identifying differences in credit spreads or default risk among bond issuers.
• Liquidity: Strategy capturing the premium demanded by investors for less liquid assets.

Each factor has its own risk-return profile and can go through long periods of outperformance or underperformance. Factor-based investing is, in many ways, an extension of the famous Fama-French research that identified size (small vs. large) and value (cheap vs. expensive) as notable drivers of equity returns. It’s now common to talk about a broader suite of factors.

The Traditional Asset Class–Based Approach

In contrast, the traditional approach to asset allocation usually classifies investments into broad brackets such as “U.S. Equity,” “Non-U.S. Equity,” “Investment-Grade Fixed Income,” “High-Yield Fixed Income,” “Real Estate,” etc. Then the manager looks at historical return and volatility patterns for these asset classes, as well as the correlations among them, to form a strategic or tactical asset allocation.

Though this approach has certainly stood the test of time, one limitation is the “averaging effect.” For example, “U.S. Equity” may include a wide range of styles, from value to high-growth technology, each with different factor exposures. The asset class label lumps these different underlying factors into one basket, sometimes obscuring the real vulnerabilities or opportunities within the portfolio.

Below is a quick conceptual flowchart that distinguishes a traditional asset class–based approach:

    flowchart LR
	    A["Investment Universe <br/> (Stocks, Bonds, etc.)"] --> B["Group by Asset Class <br/> (Equity, Fixed Income)"]
	    B --> C["Optimize & Allocate <br/> by Asset Class SAA"]
	    C --> D["Implementation & Ongoing <br/> Monitoring by Asset Class"]

While the traditional approach remains a useful and straightforward starting point, especially for investors new to portfolio construction, it may not provide the most intricate view of risk exposures.

Factor-Based Asset Allocation Process

Unlike focusing on asset class buckets, the factor-based approach aims to identify and manage risk factor exposures directly. Let’s say your policy or strategy emphasizes capturing the “value” and “quality” premiums in equities while avoiding too much “momentum” or “size” risk. By explicitly targeting these factor tilts, you can tailor your portfolio to a more refined set of risks that align with long-term performance expectations.

Here’s a simplified flowchart of a factor-based approach:

    flowchart LR
	    A["Investment Universe <br/> (Stocks, Bonds, Real Assets)"] --> B["Identify Risk Factors <br/> (Value, Momentum, Credit, etc.)"]
	    B --> C["Allocate by Targeted <br/> Factor Exposures"]
	    C --> D["Implementation & <br/> Factor Monitoring"]

Implementation Considerations

• Factor Indices and ETFs: A common way to implement factor investing is to use specialized indices or ETFs designed to capture the target factor. For instance, you might allocate to a “Value” ETF that screens for undervalued stocks using certain valuation metrics.

• Customized Mandates: Some institutional investors create customized mandates for their managers. They say, “We want a 50% tilt toward value, 30% tilt toward momentum, and 20% tilt toward low volatility.” Each of these factors can be constrained to a certain tracking error or maximum risk built into the mandate.

• Derivatives and Overlays: Another possibility is to use derivatives such as swaps or futures overlays to gain or hedge specific factor exposures. For example, an investor might overlay a momentum swap on top of a broad equity portfolio if they expect strong momentum to continue in the near term.

• Factor Drift and Rebalancing: Factor exposures are not static; they drift over time due to market movements and changes in fundamental data. Regular monitoring and rebalancing (or re-optimizing) is crucial to maintain the intended factor profile.

Benefits of Factor-Based Allocation

Improved Diversification

One of the biggest promises of factor-based investing is deeper diversification. Sometimes when you hold multiple asset classes, you’re effectively doubling down on the same factor exposure—especially during times of crisis. By analyzing and managing exposures systematically, you can reduce the unintended overlap of similar risk factors.

Real estate, for instance, may have a “value” tilt in certain economic environments if properties are trading below replacement cost, or it might have a strong exposure to “liquidity risk” if transaction volumes are low. Looking at real estate purely as its own asset class might not give you that nuanced perspective.

Greater Transparency and Control

By dissecting your portfolio into factors, you can see exactly how and why your portfolio might behave in different markets. It’s empowering. Instead of simply saying, “I hold 40% equities, so it might drop if equities fall,” you can see that your equity holdings have, say, 60% in “value” and 40% in “growth,” or that your overall “credit risk” might be 25% of total portfolio risk, scattered across corporate bonds, certain real estate assets, and even some large-cap equities.

Potential for Enhanced Return

Because certain factors like value, small-cap, and momentum have historically outperformed broad market benchmarks over the long run (albeit with higher volatility or drawdowns at times), targeting those factors can potentially enhance returns. Of course, there is no guarantee that historical factor premiums will persist, but the academic evidence suggests some factors may indeed offer a structural premium.

Challenges and Potential Pitfalls

Factor Definition Ambiguity

Factors often vary depending on whose research you read. My “value” factor might be price-to-book, while another person’s “value” factor might rely on price-to-earnings or free cash flow yield. These definitions can lead to different portfolios and potentially different results.

Factor Cyclicality

Like any risk premium, factors can underperform for extended periods. The “value” factor, for example, notably lagged “growth” for a considerable stretch during certain market cycles (especially in the late ’90s tech boom and more recently during the prolonged growth stock rallies). Investors must maintain discipline or decide to pivot if they no longer believe in a certain factor’s long-term efficacy.

Complexity in Monitoring

Managing factor exposures can be data-intensive. You’ll need to track how factor loadings evolve, ensure no single factor is dominating the portfolio, and remain vigilant about changes in liquidity conditions or credit spreads that might alter factor correlations. This can be more sophisticated than a broad-based approach.

Potential Overcrowding

The more popular factor investing becomes, the greater the chance that certain factor premiums get “arbitraged away,” or at least compressed. If everyone piles into the same factors—say, low volatility or momentum—the returns might be eroded over time, and drawdowns can become more extreme if many investors flee crowded positions simultaneously.

Comparing Factor-Based vs. Traditional Asset Class–Based Approaches

Here’s a simple overview table to summarize the main differences:

Both methods can coexist. In practice, many institutional investors employ a hybrid approach. They start with traditional asset class allocations (like 60/40 or a global multi-asset mix) and then refine these allocations by factoring in known exposures they want or do not want.

Real-World Example

Imagine a pension fund that sets a strategic asset allocation of 50% global equities and 50% global fixed income. After analyzing the underlying holdings, the fund’s managers realize the portfolio has a pronounced momentum tilt in equities (lots of tech stocks with rapid price appreciation) and a heavy tilt toward credit risk in the bond portion (largely corporate and emerging market debt). The fund’s factor-based analysis reveals that during an economic downturn or when market liquidity dries up, these two supposedly diverse asset classes might behave similarly—both are sensitive to shifts in risk appetite.

By shifting some equity allocation to a “value” or “quality” focus, and rebalancing some of the bond holdings from high-yield to safer government bonds, the managers can reduce the portfolio’s overall cyclical tilt. They’re not fundamentally altering the 50/50 mix, but they’re refining the factor exposures underneath that mix. This is the essence of how factor-based insights can improve traditional allocations without completely rewriting the playbook.

Best Practices

• Develop a Clear Factor Policy: Decide which factors you believe in and have a strong rationale for. If you allocate capital to a “value” tilt, be sure you understand why (e.g., academic evidence, historical premia, alignment with investment philosophy).

• Diversify Across Factors: Instead of betting on a single factor, spread out exposures across different ones—like value, momentum, low volatility, size—since correlations among factors can shift over time.

• Monitor Correlations Over Time: Keep an eye on factor correlations, because they’re not static. During a market drawdown, certain factors can become more correlated than normal.

• Align with Objectives and Constraints: Before you jump into factor-based investing, align the factor approach with your overall objectives. If, for instance, you have liabilities that move with interest rates, you might want to emphasize certain credit or interest-rate factors (see also liability-relative approaches in other chapters).

• Stay Disciplined: Factor performance can be volatile, so avoid capitulating too soon if a core pillar underperforms for a while. Evaluate whether your thesis has changed or if it’s just a cyclical slump.

Exam Tips and Guidance

In the CFA Level III exam, factor-based investing might show up in portfolio construction or risk management questions. Be ready to:

• Identify the underlying factors driving a scenario’s performance.
• Compare a factor-based approach to a traditional approach, detailing pros/cons.
• Propose solutions to mitigate unintended factor exposures.
• Demonstrate how you would implement factor investing using specific instruments (ETFs, derivatives, etc.).

You might also see item sets asking you to interpret a table with factor loadings or to recommend a rebalancing strategy to reduce factor concentration risk. Approach those by clearly identifying the factor exposures and explaining how changes in the economic or market environment might reward or penalize those exposures.

Concluding Thoughts

Factor-based investing is like using a more detailed map. You see the twists and turns, the hills and valleys, instead of just the highway routes. Sure, you can still do a great job navigating with a broad, well-known route (traditional asset class approach), but if you’re the type of investor who wants to optimize for every potential avenue (or risk), then factor-based investing might be your jam.

Either way, the two approaches are not mutually exclusive. A well-rounded investor can blend them—start with an asset class baseline and then tweak exposures to reflect desired factor tilts. As always with investing, the true magic lies in knowing where you are, where you want to go, and how best to get there in a way that meets your risk, return, and liability requirements.

References and Further Reading

• Bender, Jennifer, Briand, Remy, Melas, Dimitris, and Subramanian, Raman. Foundations of Factor Investing. MSCI Research.
• Fama, Eugene, and Kenneth French. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics.
• CFA Institute. “Factor Investing” topic modules in the CFA Program Curriculum.

Test Your Knowledge: Factor-Based vs. Traditional Asset Allocation