Practical Applications of Portfolio Optimization with Active, Passive, and Factors: Removing the Ad Hoc Step

In Portfolio Optimization with Active, Passive, and Factors: Removing the Ad Hoc Step, from the March 2020 issue of The Journal of Portfolio Management, Roger Aliaga-Diaz, Giulio Renzi-Ricci, Ankul Daga, and Harshdeep Ahluwalia, all with The Vanguard Group, discuss a more streamlined way to optimize portfolios. They present a quantitative asset-allocation framework that incorporates active, passive, and factor strategies—and propose a utility optimization model that concurrently allocates assets among investments in these three dimensions. Their approach condenses portfolio optimization into one step that integrates investors’ risk tolerance into asset allocation. The model incorporates investor risk preferences shaped by the uncertainties inherent with active, passive, and factor investment returns. By clarifying investors’ decision-making, this approach steers them away from ad hoc portfolio allocations and permits them to customize their portfolios more deliberately. The authors highlight practical applications, including how the approach can be used to substitute lower-cost factor strategies for higher-cost active strategies and to create factor-tilted portfolios aligned with investors’ varying risk thresholds. TOPICS: Analysis of individual factors/risk premia, factor-based models, portfolio theory, portfolio construction