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

CHAPTER 5

Factor Models

Guofu Zhou, Ph.D. Frederick Bierman and James E. Spears Professor of Finance Olin Business School, Washington University

 

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

 

 

 

 

 

Given a set of assets or asset classes, an important task in the practice of investment management is to understand and estimate their expected returns and the associated risks. Factor models are widely used by investors to link the risk exposures of the assets to a set of known or unknown factors. The known factors can be economic or political factors or industry factors or country factors, and the unknown factors are those that best describle the dynamics of the asset returns in the factor models. However, they are not directly observable or easily intrepreted by investors and have to be estimated from the data.

Applications of the mean-variance analysis and portfolio selection theories in general require the estimation of asset expected asset returns and their covariance matrix. Those market participants who can identify those true factors that drive asset returns should have much better estimates of the true expected asset returns and the covariance matrix to form a much better portfolio than otherwise possible. Hence, there is a lot of research and resources devoted to analyzing factor models in practice by the investment community. There is an intellectual “arms race” to find the best portfolio strategies to outperform ...