Portfolio Factor Allocation Schemes

Factor allocation decisions are becoming a prominent consideration for factor investors. Which factors to allocate to, and in what magnitude, has a significant impact on investment outcomes and should be a key focus of investors.

Introduction

The decision over which factors to allocate to, and in what magnitude, has a significant impact on investment outcomes and is an important consideration for investors employing a factor approach to achieve investment objectives. It is analogous to the asset allocation decision within a multi-asset context and is particularly relevant given the increasing popularity of factor investing and the growth in multi-factor investment products. 

As with asset allocation, different investors have different objectives. For example, investors employing a defensive equity strategy may allocate to defensive factors such as Quality or Low Volatility. Alternatively, investors with views on the likely magnitude of future factor returns may follow a dynamic allocation strategy. Often, investors are just seeking to improve risk-adjusted performance outcomes and will select a combination of factors for this purpose. However, the allocation or size of the relative exposures to each factor is often disregarded, leading to unnecessary risk concentrations.

In this paper, the authors compare the outcomes of three formal schemes for determining the allocation to a given set of factors. In the absence of specific views on expected factor returns, a logical objective is to diversify across the range of factors. Three potential allocation schemes are:

• Equal Exposure (EE): equal levels of factor exposure
• Risk Exposure (RE): factor exposure is inversely proportional to the volatility of factor returns, i.e., higher exposure to less volatile factors
• Equal Risk Contribution (ERC): factor exposure is determined such that each factor contributes equally to active risk 

Each of these schemes corresponds to a well-known stock level portfolio construction process, where weight is allocated to individual stocks to yield equally-weighted, risk-weighted and equal-risk contribution portfolios respectively. Here, authors note that such allocation schemes are applicable at the level of factors and that the differences between each scheme may be examined through the assumptions made regarding knowledge of future factor returns, volatilities and correlations.