Equity Valuation and Portfolio Management

DESIRABLE PROPERTIES OF FACTORS

Factors should be founded on sound economic intuition, market insight, or an anomaly. In addition to the underlying economic reasoning, factors should have other properties that make them effective for forecasting.

It is an advantage if factors are intuitive to investors. Many investors will only invest in a particular fund if they understand and agree with the basic ideas behind the trading strategies. Factors give portfolio managers a tool in communicating to investors what themes they are investing in.

The search for the economic meaningful factors should avoid strictly relying on pure historical analysis. Factors used in a model should not emerge from a sequential process of evaluating successful factors while removing less favorable ones.

Most importantly, a group of factors should be parsimonious in its description of the trading strategy. This requires careful evaluation of the interaction between the different factors. For example, highly correlated factors will cause the inferences made in a multivariate approach to be less reliable. Another possible problem when using multiple factors is the possibility of overfitting in the modeling process.

Any data set contains outliers, that is, observations that deviate from the average properties of the data. Outliers are not always trivial to handle and sometimes we may want to exclude them and other times not. For example, they could be erroneously reported or legitimate abnormal values. Later in ...