Explain how investment factors are used both to build an asset allocation and to analyse one
The idea
Factor-based allocation starts from rewarded return drivers rather than asset class labels. Typical factors are the equity market premium, size, value, momentum, quality or profitability, together with duration, credit and currency premiums; each non-market factor is expressed as a long–short portfolio that isolates the premium. The investor decides how much exposure to take to each, then implements it with index funds, factor funds or derivatives. For analysis, regressing a portfolio's returns on factor returns reveals its true exposures and shows whether apparently distinct holdings are the same bet. Because factor portfolios can have low correlations with each other, the approach can improve diversification. The trap is ignoring the leverage, shorting and turnover costs that factor implementation requires.
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