Factor Allocation Models

Improving Factor Portfolio Efficiency

January 2018. Reading Time: 15 Minutes. Author: Nicolas Rabener.


  • Factor timing and factor risk management are related concepts, but have different objectives
  • Factors have unique characteristics that require a tailored risk management approach
  • A multi-dimensional factor risk management model shows consistent increases in risk-return ratios and decreases in maximum drawdowns across markets


Smart beta funds surpassed $1 trillion assets under management in 2017 and factor long-short products have approximately half of that amount in assets. Both product families are based on academic research that has shown that some factors generate positive returns across time, countries and sectors. However, factors, like equity markets, exhibit highly cyclical behaviour and experience significant multi-year drawdowns, which means it is risky for investors to focus exclusively on a single factor. Given this, investors tend to diversify across several factors, which raises the question of how to allocate to factors. In this white paper we will analyse two common approaches to factor allocations, which are equal-weight and risk parity models, and introduce an alternative, which we term the “multi-dimensional factor risk management model” (read Factor Allocation 101: Equal vs Volatility-Weighted).


We focus on the following six factors: Value, Size, Momentum, Low Volatility, Quality and Growth and the following seven markets: US, Europe, UK, Japan, Australia, Hong Kong and Singapore. The factors are constructed as beta-neutral long-short portfolios by taking the top and bottom 10% of the stock universes in the US, Europe and Japan and 20% in other markets given smaller stock universes. Only stocks with market capitalisations of larger than $1 billion are considered and 10 basis points of costs per transaction are included. The analysis covers the period from 2000 to 2017.

There are three core approaches for creating multi-factor portfolios (please see our white paper Multi-Factor Models 101 for further information):

  • Combination approach: Stocks are ran