Chapter 39. Dynamic Factor Approaches to Equity Portfolio Management

DORSEY D. FARR, PhD, CFA

Principal, French Wolf & Farr

Abstract: Dynamic factor models are widely used in modern portfolio management. These models are based on factors such as equity style, industry or geographic location, macroeconomic factors (e.g., the term structure of interest rates, credit spreads, inflation, and GDP growth), or microeconomic factors (e.g., beta, liquidity, profitability, or leverage). Modeling of the time series variation in factor exposure is based on a variety of methods, including relative value spreads, momentum and trends, as well as other combinations. The implementation of these strategies is challenging, but it has been facilitated by new developments in modeling, benchmarking, computing power, and trading technology. Implementation may be achieved at the macro level—via direct exposure to one or more factors—or at the micro level through factor based security selection models.

Keywords: portfolio management, style management, factor models, tactical asset allocation, portfolio attribution, return attribution, fundamental factors, momentum, valuation, indexes, exchange-traded funds (ETFs)

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, ...

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