Index + Factors + Alpha

We establish, under both theoretical conditions and empirical application, the separate roles of (1) market asset class exposure through index funds; (2) style factor exposure like value, momentum, and quality which have traditionally delivered higher and differentiated returns than market index exposure; and (3) pure alpha-seeking sources of return in excess of index and factor returns. We develop a new methodology to determine optimal allocations of index, factors, and alpha-seeking funds by imposing priors on the information ratios of factors and alpha strategies. We expect in most cases, prior standard deviations for factor funds should be smaller than alpha strategies, given the economic rationale and relatively long histories of factor strategies. The means and covariances from the predictive distribution can be used as inputs in standard optimization procedures