Practical Considerations for Factor-Based Asset Allocation

Much has been written about the shortcomings of the traditional approach to asset allocation. Traditional asset allocation policies can typically be characterized by relatively static asset allocation and by diversification across asset class building blocks. As asset class returns are largely driven by common risk factors such as growth and inflation, traditional balanced portfolios can be poorly diversified, with a pro-cyclical growth bias that may lead to significant drawdowns and losses in the event of market turmoil. Against this backdrop, there has been an emerging shift, especially among institutional investors, toward more dynamic asset allocation, hinged on diversification across risk factors.Exactly how risk factors should be included in the portfolio construction process is still a nascent area of research and is fiercely debated among practitioners. While there are numerous research papers that explore this topic, they tend to be theoretical, and it is for this reason that this paper has a stronger focus on the practical aspects of implementation. Rather than provide definitive answers here, we aim to share our reflections on this topic, following feedback from practitioners and discussions that took place in client roundtable events S&P Dow Jones Indices organized to promote dialogue with industry experts