Equity Valuation and Portfolio Management

KEY POINTS

• The four most commonly used approaches for the evaluation of return premiums and risk characteristics to factors are portfolio sorts, factor models, factor portfolios, and information coefficients.
• The portfolio sorts approach ranks stocks by a particular factor into a number of portfolios. The sorting methodology should be consistent with the characteristics of the distribution of the factor and the economic motivation underlying its premium.
• The information ratio (IR) is a statistic for summarizing the risk-adjusted performance of an investment strategy and is defined as the ratio of average excess return to the standard deviation of return.
• We distinguish between contemporaneous and forecasting factor models, dependent on whether both left- and right-hand side variables (returns and factors) have the same time subscript, or the time subscript of the left-hand side variable is greater.
• The three most common violations of classical regression theory that occur in cross-sectional factor models are (1) the errors in variables problem, (2) common variation in residuals such as heteroskedasticity and serial correlation, and (3) multicollinearity. There are statistical techniques that address the first two. The third issue is best dealt with by removing collinear variables from the regression, or by increasing the sample size.

  EXHIBIT 12.14 Total Return Report (annualized)

• The Fama-MacBeth regression addresses the inference problem caused by the correlation of the residuals ...