Fuzzy Factors and Asset Allocation

In this article, the authors discuss asset allocation through the factor exposure lens. They argue that a factor dimension brings novel challenges, including ambiguity in investor objectives, a multitude of suitable factor definitions, and the time-varying nature of asset/factor correlations. Such new classes of uncertainties do not fit neatly into the probabilistic framework that is at the core of modern portfolio theory. As a remedy, the authors suggest leveraging fuzzy set theory, which has been specifically created to deal with ambiguities in process objectives, component definitions, and relationships. The authors review basics of the theory, illustrate how to apply it to portfolio optimization problems, and discuss practical application of such a fuzzy asset allocation framework.