Chapter 12Factor-Based Equity Portfolio Construction and Performance Evaluation

The analytic approaches described in Chapter 11 are better suited for equity portfolio managers who are comfortable with the idea of quantitative portfolio management. Even equity portfolio managers who do not consider themselves quantitatively oriented, however, use portfolio analytics to some degree. For example, they may not use optimization for portfolio allocation and rebalancing, but they may use data and analysis for stock screening, or simulation in the portfolio performance evaluation process.

Factor models have become a key driver for the use of analytics in portfolio construction and risk management. Equity investment strategies are often based on factor groupings, where the factors can include value, growth, volatility, and liquidity. Portfolio diversification across managers pursuing various alpha strategies has given way to diversification across betas for multiple strategically selected factors. Identifying and incorporating such factors in the investment process requires deeper comfort with analytical techniques than has been traditionally required.

This chapter describes in detail how factors enter into the process for selecting equity investments, portfolio construction, and portfolio evaluation. We begin with a list of typical factors used in equity portfolio construction and then show explicit examples of how factors are used for stock screening, portfolio construction, stress ...

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