Advanced Portfolio Management

Chapter 7Manage Factor Risk

• What will you learn here: Three things. First, how to easily adjust portfolio positions in order to reduce factor risk. Second, how to think about risk parameters and risk limits. Lastly, how to plan for systematic portfolio construction in order to achieve greater execution efficiency and investment productivity.
• Why do you need it: Because, in the majority of cases, portfolio management is an interactive process. You will act on your portfolio when risk is unacceptably high, and to do it, you will need to know what “unacceptably high” risk is, and how to bring it to an acceptable level. You will need some systematic portfolio construction when your strategy becomes sufficiently big and complex.
• When will you need this: You will use tactical portfolio management daily; you will perform portfolio optimization occasionally (say, once a month or less). You will set risk limits rarely (less often than once a year), but will need to understand and embrace them once and for all – an important step. Maybe you will never need systematic portfolio construction tools. But when the time comes, they will be the only thing you need, until they are in place.

7.1 Tactical Factor Risk Management

If you are a fundamental investor, factor returns are the cross-currents that can wreak your portfolio. A recurrent theme in this book is that, as soon as your portfolio is sufficiently broad (say, more than 50 stocks), you should not have large factor exposures ...