English Portfolio Management

Factor investing: Theory

Factors are investment characteristics and investors expect premia through exposure to the corresponding risks

Factor models allow investors to understand and manage the sources of risk in a portfolio. By using a limited set of factors, they simplify the analysis of portfolios composed of many assets. They are also useful in performance attribution to understand the source of performance and the skills of active managers.

The use of common investment characteristics (or factors) has a long tradition in portfolio management. For example, value investing has its roots in the pioneering work of Graham and Dodd in 1934. Today, investment analysts generally distinguish between three types of factors: statistical factors, economic factors and attribute factors. Statistical factors are linear combinations of securities that explain the variability of returns: they are rarely used to construct a portfolio and are difficult to interpret. Economic factors (mainly macroeconomic) are variables that capture some aspect of economic activity (see the parity model), such as growth, inflation, credit, real rates, emerging markets, liquidity, or employment. While it is easy to measure these variables, it is less easy to gain exposure to them because these factors are not directly investable. Active investors typically use these factors to make tactical bets because they change; as such, and because of the use of derivatives and leverage, they are less appropriate to passive investors.

Attribute (characteristic) factors are observable properties of securities, such as value, company size (the first two factors to be systematically used were value and size), industry, or book-to-market, that are associated with differences in returns. These attributes reflect risk, and investors will receive a premium for bearing the corresponding risk by having exposure to them. Because of their practical appeal, attribute factors are the most widely used in investment management: In equities, the MSCI global equity model introduced in 2015 is widely used and includes eight factor groups: value, size, momentum, volatility, quality, yield, growth and liquidity. These eight factor groups have been extensively researched and are used in practice to describe stocks and support portfolio decisions.

In practice, some argue that the factors could even replace asset classes as drivers of asset allocation decisions, but due to their lack of investability and added complexity, this approach is not suitable for retail investors that should take a passive approach. More advanced investors, however, can analyze economic factors for their forecasts and use attribution factors to understand portfolio risk factors, while retaining asset classes as investing blocks.

Factor Allocation Model: Integrating Factor Models and Strategies into the Asset Allocation Process, The Journal of Portfolio Management, Volume 47, Issue 5, 2021 , Dimitris Melas
The Role of Factors in Asset Allocation, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Mark Kritzman
Factor Allocation as Reverse Attribution, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Joseph Simonian
Macro Factor Model: Application to Liquid Private Portfolios, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Scott Gladstone, Ananth Madhavan, Anita Rana, and Andrew Ang