An alternative framework for estimating input is to work down to the underlying determinants, or factors, that drive the risk and returns of assets. If we understand how the factors influence returns, and we understand the factors, we will be able to construct more robust portfolios.

The concept of factor investing looks beyond asset class labels to the underlying factor risks to maximize the benefits of diversification. Rather than distinguishing investment vehicles by labels such as hedge funds or private equity, factor investing aims to identify distinct risk-return profiles based on differences in exposure to fundamental risk factors. The naïve approach to mean-variance investing plugs (artificial) groupings as distinct asset classes into a mean-variance optimizer. Factor investing recognizes that such groupings share many of the same factor risks as traditional asset classes. Diversification benefits can be overstated, as investors discovered during the last crisis when correlations among risky asset classes increased due to exposure to the same underlying factor risks.