Factor allocation

Factor allocation is a way of creating a portfolio by using quantifiable characteristics or “factors”. Similarly to asset allocation, where the investor has to choose the correct weight of each asset, the most crucial thing in factor allocation is to choose the accurate weight of each factor. Secondly, the investor has to time when to go long/short on individual factors. For example, investors utilizing 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 looking for ways 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.

Macroeconomic factors and style factors are two main types of factors that have driven returns of stocks, bonds, commodities, and other assets. Macroeconomic factors capture broad risks across asset classes, while style factors aim to explain returns and risks within asset classes.

Academics have shown that momentum strategies can generate extraordinary excess returns in virtually every asset class, and they are also applicable to factor portfolios. An example of this could be Momentum Factor and Style Rotation Effect, Momentum in FOREX Trading Strategies or Switching between Value and Momentum in Stocks.

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