Equity Valuation and Portfolio Management

KEY POINTS

• Advances in computational technology, introduction of new benchmarks and trading tools, and a decline in the cost of computing power have all driven changes in the techniques of portfolio management over the past decade.
• All active portfolios can be decomposed into an active component and a passive (benchmark replicating) component.
• Dynamic factor models are used to build portfolios based on tactical exposure to factors such as equity style, industry or geographic location, macroeconomic factors, or microeconomic factors.
• Factor models have a close relationship with theoretical asset pricing models.
• Dynamic factor strategies attempt to eliminate sources of security-specific risk.
• Portfolio managers use a variety of methods for modeling the time series variation in factor exposure, including relative value spreads, momentum and trends, as well as other combinations.
• Both value and momentum strategies have been shown to be effective for security selection within particular markets as well as selection across markets (e.g., sectors or countries).
• Implementation of dynamic factor approaches to portfolio management has been facilitated by new developments in modeling, benchmarking, computing power, and trading technology.
• Many dynamic factor models may be implemented at the macro level—via direct exposure to one or more factors—or at the micro level through factor-based security selection models.