Looking Beyond Asset Classes: A Factor Lens for Investing

Why Asset Allocators Should Think Differently About Risk

Institutional portfolios are usually described in the language of asset classes.
  • Equities.
  • Government bonds.
  • Private equity.
  • Infrastructure.
  • Real estate.
  • Private credit.
These categories are familiar, practical, and easy to report. However, I believe portfolio construction should not begin with them.
Asset classes are implementation choices, not the true sources of risk. Long-term investors are rewarded for bearing risk, not just for holding asset classes. To understand portfolios, we must look deeper.

Not All Factors Are the Same

When investors hear the term factor, many immediately think of value, momentum, quality, or size. These factors have transformed active equity management and remain important tools for asset managers. However, they address a different question. They help explain why one portfolio of equities may outperform another.
Asset allocators face a different problem. Our task is not to choose between two equity managers. Our task is to determine how the institution should allocate risk across the entire balance sheet. That requires a different set of factors.

The Factors That Matter to Asset Allocators

From an asset allocation perspective, I find it useful to start with a few key macroeconomic forces.
  • Economic growth.
  • Real interest rates.
  • Inflation.
These are not the only forces affecting markets. Nor do they explain every movement in every asset. However, much of the long-term behaviour of traditional asset classes can be explained by their response to these three macroeconomic drivers.
For instance, equities are largely claims on future economic growth. Government bonds are highly sensitive to changes in real interest rates. Real assets often derive much of their long-term value from their sensitivity to inflation. Most investment vehicles can be viewed as different combinations of these underlying exposures.
This perspective changes the conversation.
Instead of asking,
“Should we own more infrastructure?”
we begin asking,
“Which macroeconomic risks are we trying to own?”

The Mandate Determines the Factors

This is also why I believe factor investing for asset allocators should not begin with factors. It must begin with the mandate.
Different institutions are exposed to different economic risks. A defined benefit pension plan with inflation-linked benefits faces a fundamentally different investment problem from one without cost-of-living adjustments. An insurance company faces different liabilities from an endowment. A sovereign wealth fund has different objectives from a central bank.
If the institution itself is not particularly sensitive to inflation, why should inflation protection occupy a significant share of the portfolio? Conversely, if inflation directly affects the institution’s liabilities, ignoring inflation risk becomes much more difficult to justify.
The importance of a factor depends not only on financial markets but also on the institution’s economic reality. The mandate tells us which risks matter. The factors simply provide a language for expressing them.

A Small Number of Factors Often Goes a Long Way

A common temptation in portfolio construction is to keep adding more factors.
Each may have merit, but added complexity does not always lead to progress. For strategic asset allocation, I believe there is value in beginning with a parsimonious framework.
The objective is not to describe every source of return. It is to identify the macroeconomic risks that matter most for the institution’s long-term objectives. Additional factors should be introduced only when they genuinely improve understanding. They should not be included simply because they exist.

Factors Before Asset Classes

Once we adopt a macro factor perspective, asset classes appear differently. They serve as implementation vehicles rather than investment objectives.
Different portfolios may contain different assets while expressing remarkably similar macroeconomic exposures. Conversely, two portfolios that appear similar may have very different underlying risk characteristics. Focusing only on asset classes can therefore be misleading.
The more fundamental question is whether the portfolio provides the desired exposures to the macroeconomic risks that matter for the institution.

Looking Ahead

Once portfolios are viewed through a factor lens, another question arises.
  • If factors are the underlying source of risk, what role do public and private markets actually play?
  • Are they fundamentally different investment opportunities?
  • Or are they often different ways of accessing many of the same underlying risk exposures?
That will be the subject of my next article.

References

  • Andrew Ang, Asset Management: A Systematic Approach to Factor Investing.
  • Anna Cieslak & Carolin Pflueger, Inflation and Asset Returns, Annual Review of Financial Economics, 2023.
* Images generated using ChatGPT

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