The Appeal of Factor-Based Allocations

Ashby Monk

In the wake of the credit crunch, ‘factor based allocation strategies’ have become the hot new trend, as a growing number of funds are looking to adopt “risk-oriented” asset allocation policies rather than the traditional “asset-oriented” allocations. It seems that the credit crisis of 2007-09 demonstrated to many institutional investors that they didn’t really understand the risks they were taking (just as the “perfect storm” of 2001-03 taught many funds that they didn’t really have their assets aligned with their liabilities).

I thought I’d sketch out some of the basic ideas underpinning the factor-based approach, and Columbia’s Andrew Ang offers an eloquent starting point:

“Factors are to assets what nutrients are to food…Factors are the nutrients of the financial world. Factor theory is based on the principle that factor risk must be compensated and factors are the driving force behind risk premiums…This is the modern theory of asset pricing: assets have returns, but these returns reflect the underlying factors behind those assets.”

The reason factors are so important is that traditional asset classes will generally have exposures to the same underlying risk factor. In other words, an asset allocation based on equities, bonds, and alternatives may ultimately be providing very little diversification in terms of the underlying factors that drive returns. So, by focusing on the factors, an investor can better grasp what asset classes will provide the desired risk exposures. As Ang notes, “Factors allow a more holistic view of the investment and business activities of a fund.”

During the credit crunch, the “asset-oriented” approach didn’t provide the amount of diversification that the funds had expected/hoped. All the assets in their portfolios seemed to be moving in the same direction: down. For example, take CalPERS, which is one of the most diversified investors in the world. It lost $100 billion in roughly 18 months — the fund was worth $260 billion in October 2007 and touched $160 billion in March 2009.

As you can imagine, then, CalPERS is one of the funds leading the charge into factors. As I see it, this new approach simply provides the funds with more information about their risk exposures, and that has to be a very good thing.

As for CalPERS, its new “Alternative Asset Classification” will take effect in July 2011 and have the following components: Income: 15.9%; Growth: 63.1%; Real: 13.0%; Inflation-Linked: 4.0%; and Liquidity: 4.0%. And what does all that mean in “traditional” terms? Here’s a translation:

6 Responses to “The Appeal of Factor-Based Allocations”


  1. 1 Victoria Barbary February 10, 2011 at 12:17 am

    The IMF have also recently been looking at this. A January paper “Investment objectives of Sovereign Wealth Funds – a shifting paradigm” looks at an odd group of SWFs (who’d have thought that Timor Leste would have got so much airplay) but I think in looking at data they’re pretty hamstrung.

    Anyway, the paper isn’t dissimilar in its conclusions. Particularly it looks to “investment horizon” (cf. your recent post on Norway). The concluding point I like best is “the crisis demonstrates the importance of macro-stability risk assessment and careful consideration of the financing options of the sovereign both in normal times and during financial stress”. In other words, most SWFs didn’t have proper risk management in place pre-crisis…

    Not revelatory, but an interesting read anyway.

    • 2 Ashby Monk February 10, 2011 at 9:34 am

      Thanks, Vee. Interesting to note that APF has also been moving towards the factor allocations. However, Norway (via Dimson) decided against a facto approach. Whatever the case…this is the new, new thing!

  2. 3 Sven Behrendt February 10, 2011 at 2:18 am

    A thought provoking entry, Ashby, suggesting a very interesting conversation to be pursued about a reconsidered notion of risk assessement, risk management, and resulting risk oriented asset allocations in the SWF world and beyond. I have the impression that the consideration of non-financial risks, or “factors”, in the financial services industry is still undervalued. Some risks seem to be too far off and you “can’t quantify them anyway”, though I would understand them to be core to comprehend relevant “factors”. The result is that many investors have at best only a fragmented and highly selective idea what is happening beyond narrower analytical boundaries (which were helpful and relevant at one time), and consider what is happening beyond these boundaries as “noise”. This examplains, to use but one example from the world of SWFs, why the SWF community was taken so aback in 2007 by public concerns and had a hard time organising themselves (individually and collectively), which in turn had a substantial impact on their asset allocation. So my plea is to be more rigorous in the treatment of broader risks.

    • 4 Ashby Monk February 10, 2011 at 9:36 am

      Interesting. If you’re going to look at the factors, why not include things like “geopolitical risk” then. And if that’s the case, maybe we should give some thought to what products best provide exposure to this sort of risk. Infrastructure in Africa?

      • 5 Sven Behrendt February 11, 2011 at 2:25 am

        Exactly, Ashby. That would be a great added value! Btw. I am not only astonished by the the lack of political foresight and capacity within the financial community to translate (geo-)political event and long-term risks into factor-based asset allocation; you find that amongst policy makers too, see Egypt. But that’s another story.


  1. 1 From ‘Risk Allocations’ To ‘Risk Organizations’ « Oxford SWF Project Trackback on June 15, 2011 at 12:15 pm

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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