Equity Valuation and Portfolio Management

CHAPTER 11

Factor-Based Equity Portfolio Construction and Analysis

Petter N. Kolm, Ph.D.

Deputy Director of the Mathematics in Finance Masters Program and Clinical Associate Professor, Courant Institute of Mathematical Sciences, New York University

Joseph A. Cerniglia

Visiting Researcher, Courant Institute of Mathematical Sciences, New York University

Frank J. Fabozzi, Ph.D., CFA, CPA

Professor of Finance, EDHEC Business School

Common stock investment strategies can be broadly classified into the following categories: (1) factor-based trading strategies (also called stock selection or alpha models), (2) statistical arbitrage, (3) high-frequency strategies, and (4) event studies. Factors and factor-based models form the core of a major part of today's quantitative trading strategies. The focus of this and the companion chapter that follows is on developing trading strategies based on factors constructed from common (cross-sectional) characteristics of stocks. For this purpose, first we provide a definition of factors. We then examine the major sources of risk associated with trading strategies, and demonstrate how factors are constructed from company characteristics and market data. The quality of the data used in this process is critical. We examine several data cleaning and adjustment techniques to account for problems occurring with backfilling and restatements of data, missing data, inconsistently reported data, as well as survivorship and look-ahead biases. In the last section ...