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

KEY POINTS

• There are three types of multifactor equity risk models that are used in practice: statistical, macroeconomic, and fundamental. The most popular is the fundamental model.

• A multifactor equity risk model assumes that stock returns (and hence portfolio returns) can be explained by a linear model with multiple factors, consisting of “risk index” factors such as company size, volatility, momentum, etc and “industry” factors. The portion of the stock return that is not explained by this model is the stock-specific return.

• The risk index factors are measured in standard deviation units, while the industry factors are measured in percentages.

• The real usefulness of a linear multifactor model lies in the ease with which the risk (i.e., the volatility) of a portfolio with several assets can be estimated. Instead of estimating the variance-covariance matrix of its assets, it only necessary to estimate the portfolio’s factor exposures and the variance-covariance matrix of the factors, a computationally much easier task.

EXHIBIT 13.11 Factor Exposures of a Portfolio Tilted Towards Earnings Yield

• The variance-covariance matrix of the factors and the factor exposures of stocks are calculated based on a mix of historical and current data, and are updated periodically.

• Total risk of a portfolio can be decomposed in several ways. The partitioning method chosen is based ...