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

APPLICATIONS IN PORTFOLIO CONSTRUCTION AND RISK CONTROL

The power of a multifactor risk model is that given the risk factors and the risk factor sensitivities, a portfolio’s risk exposure profile can be quantified and controlled. The three examples below show how this can be done so that the a manager can avoid making unintended bets. In the examples, we use the Barra L3 factor model.²⁴⁰

A fundamental multifactor risk model can be used to assess whether the current portfolio is consistent with a manager’s strengths. Exhibit 13.7 is a list of the top 15 holdings of Portfolio ABC as of December 31, 2008. Exhibit 13.8 is a summary risk decomposition report for the same portfolio. The portfolio had a total market value of $5.4 billion, 868 holdings, and a predicted beta of 1.15. The risk report also shows that the portfolio had an active risk of 6.7%. This is its tracking error with respect to the benchmark, the S&P 500 index. Notice that nearly 93% of the active risk variance (which is 44.8) came from common factor variance (which is 41.6), and only a small proportion came from stock-specific risk variance (also known as asset selection variance, which is 3.2). Clearly, the manager of this portfolio had placed fairly large factor bets.

The top portion of Exhibit 13.9 lists the factor risk exposures of Portfolio ABC relative to those of the S&P 500 index, its benchmark. The first column shows the exposures of the portfolio, and the second column shows the exposures of the benchmark. ...