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Scarred by the last financial crisis, when presumably “well-diversified” asset-based portfolios declined substantially, factor-based allocation is becoming increasingly popular with institutional investors seeking to effectively diversify their portfolios (Koedijk, Slager, & Stork, 2016b Ung & Kang, 2015). Lastly, factor optimization uses the factors, instead of asset classes, as the ultimate building blocks of investment portfolios, thus deciding on a factor-based as opposed to asset-based allocation. The second approach, factor tilting, is currently the most widely used approach and refers to actively tweaking a portfolio's exposure toward certain factors based on the existing asset allocation by either introducing factors biases within the assets or complementing the assets with “pure” factors (Amenc, Deguest, Goltz, Lodh, & Martellini, 2014 Dichtl, Drobetz, Lohre, & Rother, 2020). The first, so-called risk due diligence approach, simply uses the factor methodology to gain a better understanding of the factor exposures within a previously determined investment portfolio, and to potentially revise the asset allocation accordingly. Koedijk, Slager, and Stork ( 2016a) contrast three approaches to integrating the concept of factor bundles into the investment management process.
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However, ever since the introduction of the arbitrage pricing theory (Ross, 1976), assets have been thought of as a bundle of multiple factors that reflect different risks and rewards (Ang, 2014 Ang, Goetzmann, & Schaefer, 2009 Ferson & Harvey, 1993). The capital asset pricing model (Lintner, 1965 Mossin, 1966 Sharpe, 1964) promoted the “market” as the only explanatory factor.
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The premise underlying the asset allocation decision is that, while efficiently diversifying away unrewarded (idiosyncratic) risks, the asset classes considered are still subject to an inherent return premium that can be explained by some underlying common factors. Building on the seminal work of Markowitz ( 1952), investors have traditionally focused on diversifying across broad asset classes, such as equities and bonds, when building their investment portfolios in order to balance risks and rewards.
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