CHAPTER 14

Dynamic Factor Approaches to Equity Portfolio Management

Dorsey D. Farr, Ph.D., CFA

PrincipalFrench Wolf & Farr

The term portfolio management evokes an image of a security selector—preferably a skilled one—who, like a scavenger in search of hidden treasure, dons a green eyeshade, scours the universe of securities in search of those with the most attractive prospects based on detailed financial statement analysis, and combines them together into a portfolio that will collectively provide a superior risk-adjusted return relative to some passive benchmark. For many years, this was the characteristic image of the portfolio manager and an accurate description of the practice of portfolio management. However, in response to several unique developments, the image of a portfolio manager and the practice of portfolio management have changed dramatically over the past two decades.

First, a growing body of empirical research on the success of active investment strategies employed by professional money managers has generally revealed that active management fails to live up to its promise of superior returns. The mounting acceptance of the efficient markets hypothesis—at least in its weaker forms as described by Fama1—and the understanding that active management is a zero-sum game—as articulated by Sharpe2—helped to promote the use of passive (index-based) portfolio management strategies.

Additionally, a separate literature evolved that mistakenly cast doubt on the importance of ...

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