Advanced Portfolio Management

Chapter 5Understand Factors

• What will you learn here: The definition and interpretation of the most important risk model factors, with a special emphasis on style factors.
• Why does this matter: If a factor model is the skeleton of the market, then the factors are the large muscles of the body. They literally move the markets. You may want to give them a name, and know how they do it.
• When will you need this: You will revisit this chapter during large drawdowns, looking for clues; and on a periodic basis, when you want to parse sell-side reports discussing factor “rotations”.

Factors partially explain stock returns. They exhibit trends (i.e., non-zero expected returns) and volatilities. Many of these factors were first introduced to describe puzzling returns not explained by the CAPM. Researchers provide two explanations for the existence of a non-null factor return. First, these returns could be the compensation a portfolio manager receives for the risk taken in the portfolio. Investors are rational after all, and don't leave money on the table, in the form of non-priced risk. However, some researchers push for “behavioral” explanations, in which the expected returns stem from investors' bounded rationality: investors have cognitive biases, inability to process infinite information and to perform complex optimizations in their head. I am presenting both, because, while the former seems more relevant to risk management, the latter helps the investor interpret the factor. ...