Factor Tilts and Asset Allocation

Abstract

Factor investing has received much attention from academics and practitioners, as well as from individual and institutional investors. It has become usual for investors that aim to enhance returns to add to the core of their portfolios a factor satellite, thus tilting their portfolios toward factors that have produced a long-term risk premium. However, in most cases, investors behaving this way are not fully invested in stocks, which begs an interesting question: Should an investor with a two-asset portfolio of broadly-diversified stocks and bonds tilt the stocks slice of his portfolio toward (small-cap and value) factors, or would he be better off by simply increasing the allocation to broadly-diversified stocks in his two-asset portfolio? The results discussed here, based on different samples and sample periods, support the notion of factor-tilting portfolios.

Keywords: factors, smart beta, risk minimization, return maximization

JEL Classification: G11