Contrast defining the opportunity set by traditional asset classes with defining it by risk factors, when alternatives are included

The traditional approach groups assets by their legal form and liquidity, such as equities, bonds, real estate and hedge funds, and sets an allocation for each. It is intuitive, easy to communicate and aligns with how managers are hired, but it can hide overlaps: private equity, high-yield credit and listed equity all load on the same growth factor, to different degrees. The risk-based approach groups exposures by underlying factors such as equity, interest rates, inflation, credit, currency and illiquidity, revealing the real diversification and guarding against unintended concentration. Its weaknesses are harder communication, unstable factor sensitivities and difficulty implementing factor targets through actual funds. A good answer weighs transparency and governance simplicity against better risk insight. Factor overlaps are easy to miss.