Equity Valuation and Portfolio Management

FACTOR-BASED TRADING

Since the first version of the classic text on security analysis by Benjamin Graham and David Dodd¹—considered to be the Bible on the fundamental approach to security analysis—was published in 1934, equity portfolio management and trading strategies have developed considerably. Graham and Dodd were early contributors to factor-based strategies because they extended traditional valuation approaches by using information throughout the financial statements² and by presenting concrete rules of thumb to be used to determine the attractiveness of securities.³

Today's quantitative managers use factors as fundamental building blocks for trading strategies. Within a trading strategy, factors determine when to buy and sell securities. We define a factor as a common characteristic among a group of assets. In the equities market, it could be a particular financial ratio such as the price–earnings (P/E) or the book–price (B/P) ratios. Some of the most well-known factors and their underlying basic economic rationale references are provided in Exhibit 11.1.

Most often this basic definition is expanded to include additional objectives. First, factors frequently are intended to capture some economic intuition. For instance, a factor may help understand the prices of assets by reference to their exposure to sources of macroeconomic risk, fundamental characteristics, or basic market behavior. Second, we should recognize that assets with similar factors (characteristics) tend ...