The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 13

Multifactor Equity Risk Models

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

Raman Vardharaj, CFA Vice President and Portfolio Manager OppenheimerFunds

 

Frank J. Jones, Ph.D. Professor, Accounting and Finance Department San Jose State University

 

 

 

 

 

Thus far, several chapters have discussed multifactor risk models for equity portfolio management. In Chapter 5, we described the theory of asset pricing in terms of risk factors—the arbitrage pricing theory—and mentioned the different types of multifactor risk models—statistical models, macro models, and fundamental models. The most popular type of model used in practice is the fundamental model. While some asset management firms develop their own model, most use commercially available models. While the development of a fundamental multifactor risk model involves a substantial amount of sophisticated statistical analysis and testing, model development is not the focus of this chapter. Instead, this chapter explains how a multifactor risk model is used in practice to (1) select securities, (2) quantify the risk exposure of a portfolio relative to a benchmark index, (3) construct a portfolio and control risk, and (4) measure performance.

In our illustration, we will use an old version of a model developed by Barra (now MSCI Barra). While that model has been updated, the discussion and illustrations provide the essential points for appreciating the value of ...