Factor Investing

3 and Multifactor Models

Introduction to Factor Investing

Changing Asset Management Paradigm

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Introduction to Factor Investing

Changing Asset Management Paradigm

Introduction to Factor Investing

Investor’s View of a Portfolio

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Introduction to Factor Investing

Asset Allocator’s View of a Portfolio

Introduction to Factor Investing

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Introduction to Factor Investing

A Factor Investor’s View of a Portfolio

Introduction to Factor Investing

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Multifactor Models and Modern
Portfolio Theory
• Our analysis of risky securities and the
construction of portfolio’s leads us to several
important conclusions:
– When a security is included in a portfolio part of its
risk is diversified away (its diversifiable risk)
while part of its risk contributes to the risk of the
portfolio (its non-diversifiable risk)
• The non-diversifiable risk of a security is clearly
related to the correlation of the security’s return and
the portfolio’s return; the lower the correlation, the
more diversification of risk 9

Multifactor Models and Modern

Portfolio Theory
• The concept of systematic risk is critical to under
standing multifactor models: An investment may be
subject to many different types of risks, but they are
generally not equally important so far as investment
valuation is concerned. Risk that can be avoided by
holding an asset in a portfolio, where the risk might
be offset by the various risks of other assets, should
not be compensated by higher expected return,
according to theory
• Hence it should be the non-diversifiable risk that they
are compensated for, not the diversifiable risk
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 Multifactor models

• CAPM is criticized because of

– Many unrealistic assumptions
– Difficulties in selecting a proxy for the market portfolio as
a benchmark
• Alternative pricing theory with fewer assumptions
was developed:
– Arbitrage Pricing Theory (APT)
– Macroeconomic factor models Multifactor
–… models

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Multifactor models

• A factor is a common or underlying element with

which several variables are correlated. For example,
the market factor is an underlying element with which
individual share returns are correlated.
• We search for systematic factors, which affect the
average returns of a large number of different assets.
These factors represent priced risk, risk for which
investors require an additional return for bearing.
Systematic factors should thus help explain returns.

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 Arbitrage Pricing Theory and the
Multifactor Models
• In the 1970s, Ross (1976) developed the arbitrage pricing
theory (APT) as an alternative to the CAPM

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Arbitrage Pricing Theory

Three Major Assumptions:
1. A factor model describes asset returns.
2. There are many assets, so investors can form well-
diversified portfolios that eliminate asset-specific
risk.
3. No arbitrage opportunities exist among well-
diversified portfolios.

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 Arbitrage Pricing Theory

• Arbitrage is a risk-free operation that requires no

net investment of money but earns an expected
positive net profit.
• An arbitrage opportunity is an opportunity to
conduct an arbitrage—an opportunity to earn an
expected positive net profit without risk and with
no net investment of money.
• Since no investment is required, investors can
create large positions to obtain large profits.

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Arbitrage Pricing Theory

Does not assume:

– Normally distributed security returns
– Quadratic utility function
– A mean-variance efficient market portfolio

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 Arbitrage Pricing Theory

• The APT Model

E(Ri)=λ0+ λ1bi1+ λ2bi2+…+ λkbik
where:
λ0=the expected return on an asset with zero
systematic risk
λj=the risk premium related to the j th common
risk factor
bij=the pricing relationship between the risk
premium and the asset; that is, how responsive asset i is to the
j th common factor
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Arbitrage Pricing Theory

• The APT equation says that the expected return on

any well- diversified portfolio is linearly related to
the factor sensitivities of that portfolio
• The factor risk premium (or factor price) represents
the expected return in excess of the risk-free rate for a
portfolio with a sensitivity of 1 to factor i and a
sensitivity of 0 to all other factors. Such a portfolio is
called a pure factor portfolio for factor i.

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 Arbitrage Pricing Theory

• To use the APT equation, we need to estimate its

parameters.
• The parameters of the APT equation are the risk-free
rate and the factor risk-premiums (the factor
sensitivities are specific to individual investments).
The following example shows how the expected
returns and factor sensitivities of a set of portfolios
can determine the parameters of the APT model.

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Arbitrage Pricing Theory

 Arbitrage Pricing Theory
• Suppose we have three well-diversified portfolios that are each
sensitive to the same single factor

Arbitrage Pricing Theory

• In this example, we demonstrate how to tell whether a set of
expected returns for well-diversified portfolios is consistent
with the APT by testing whether an arbitrage opportunity
exists
An example: The Carhart 4 factor
model
• The Carhart four-factor model, also known as the four-factor
model or simply the Carhart model, is a frequently referenced
multifactor model in current equity portfolio management
practice. Presented in Carhart (1997), it is an extension of the
three-factor model developed by Fama and French (1992) to
include a momentum factor.
• On the basis of that evidence, the Carhart model posits the
existence of three systematic risk factors beyond the market risk
factor. They are named, in the same order as above, the following:
– Small minus big (SMB)
– High minus low (HML)
– Winners minus losers (WML)

An example: The Carhart 4 factor

model
Comparing the CAPM & APT Models

CAPM APT

Form of Equation Linear Linear

Number of Risk Factors 1 K (≥ 1)
Factor Risk Premium [E(RM) – RFR] {λj}
Factor Risk Sensitivity βi {bij}
“Zero-Beta” Return RFR λ0

Unlike CAPM that is a one-factor model, APT is a

multifactor pricing model

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APT and CAPM

APT APT CAPM
• Equilibrium means no • Model is based on an
arbitrage opportunities. inherently unobservable
• APT equilibrium is “market” portfolio.
quickly restored even if • Rests on mean-variance
only a few investors efficiency. The actions of
recognize an arbitrage many small investors
opportunity. restore CAPM
• The expected return–beta equilibrium.
relationship can be
derived without using the • CAPM describes
true market portfolio. equilibrium for all assets.
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Comparing the CAPM & APT Models

• However, unlike CAPM that identifies the market

portfolio return as the factor, APT model does not
specifically identify these risk factors in application
• The APT is largely silent on where to look for priced
sources of risk
• These multiple factors may include
• Inflation
• Growth in GNP
• Major political upheavals
• Changes in interest rates
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Multifactor APT

• Use of more than a single systematic factor

• Requires formation of factor portfolios
• What factors?
– Factors that are important to performance of
the general economy
– What about firm characteristics?

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Where Should We Look for Factors?

• Need important systematic risk factors

– Chen, Roll, and Ross used industrial production,
expected inflation, unanticipated inflation, excess
return on corporate bonds, and excess return on
government bonds.
– Fama and French used firm characteristics that
proxy for systematic risk factors.

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Types of Multifactor models

• In macroeconomic factor models, the factors are surprises

in macroeconomic variables that significantly explain
equity returns. The factors can be understood as affecting
either the expected future cash flows of companies or the
interest rate used to discount these cash flows back to the
present.
• In fundamental factor models, the factors are attributes of
stocks or companies that are important in explaining cross-
sectional differences in stock prices. Among the
fundamental factors that have been used are the book-
value-to-price ratio, market capitalization, the price–
earnings ratio, and financial leverage.
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 Multifactor models

• In statistical factor models, statistical methods are

applied to a set of historical returns to determine
portfolios that explain historical returns in one of two
senses.
– In factor analysis models, the factors are the portfolios that
best explain (reproduce) historical return covariances.
– In principal-components models, the factors are portfolios
that best explain (reproduce) the historical return variances.

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Macroeconomic Factor Models

• The representation of returns in macroeconomic factor models

assumes that the returns to each asset are correlated with only
the surprises in some factors related to the aggregate
economy, such as inflation or real output.
• We can define surprise in general as the actual value minus
predicted (or expected) value. A factor’s surprise is the
component of the factor’s return that was unexpected, and the
factor surprises constitute the model’s independent variables.
This idea contrasts to the representation of independent
variables as returns (as opposed to the surprise in returns) in
fundamental factor models, or for that matter in the market
model.
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 Macroeconomic Factor Models

Suppose that K macro factors explain asset returns.

Then in a macroeconomic factor model, the return
of asset i can be expressed as:
Ri = ai + [bi1F1 + bi2 F2 + . . . + biK FK] + ei

where:
ai = the expected return to stock i
Fi=the surprise in the factor k, k = 1, 2, . . ., K
bik = the sensitivity of the return on asset i to a surprise in
factor k, k = 1, 2, . . ., K
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Macroeconomic Factor Models

• The macroeconomic factor model structure analyses the

return to an asset into three components: the asset’s
expected return, its unexpected return resulting from new
information about the factors, and an error term.
• Consider a factor model in which the returns to each asset
are correlated with two factors. For example, we might
assume that the returns for a particular stock are
correlated with surprises in interest rates and surprises in
GDP growth. For stock i, the return to the stock can be
modelled as
Ri  ai  bi1 FINT  bi 2 FGDP   i
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Macroeconomic Factor Models
• In macroeconomic factor models, the time series of factor
surprises are constructed first. Regression analysis is then used
to estimate assets’ sensitivities to the factors.
• In practice, estimated sensitivities and intercepts are often
acquired from one of the many consulting companies that
specialize in factor models.
• When we have the parameters for the individual assets in a
portfolio, we can calculate the portfolio’s parameters as a
weighted average of the parameters of individual assets. An
individual asset’s weight in that calculation is the proportion of
the total market value of the portfolio that the individual asset
represents.
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 An example

An example

2. State the expected return on the portfolio.

3. Calculate the return on the portfolio given that
the surprises in inflation and GDP growth are 1%
and 0%, respectively, assuming that the error
terms for MANM and NXT both equal 0.5%
 Multifactor Model Equation

ri  E ri    iGDP GDP   iIR IR  ei

ri = Return for security i

βGDP = Factor sensitivity for GDP
βIR = Factor sensitivity for Interest Rate
ei = Firm specific events

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Multifactor SML Models

E ri   rf   iGDP RPGDP   iIR RPIR

i = Factor sensitivity for GDP

GDP
RPGDP = Risk premium for GDP

 i IR = Factor sensitivity for Interest Rate
RPIR = Risk premium for Interest Rate

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 Interpretation
The expected return on a security is the sum of:
1. The risk-free rate
The expected return 2. The sensitivity to GDP
on a security is times the risk premium
the sum of: for bearing GDP risk
3. The sensitivity to
interest rate risk times
the risk premium for
bearing interest rate risk

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Macroeconomic Factor Models

• Security returns are governed by a set of broad economic

influences in the following fashion by Chen, Roll, and Ross in
1986 modeled by the following equation:
• 1) inflation, including unanticipated inflation and changes in
expected inflation,
• 2) a factor related to the term structure of interest rates,
represented by long-term government bond returns minus one-
month Treasury-bill rates,
• 3) a factor reflecting changes in market risk and investors’ risk
aversion, represented by the difference between the returns on
low-rated and high-rated bonds, and
• 4) changes in industrial production.
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 Macroeconomic Factor Models

Rit  ai  [bi1 Rmt  bi 2 MPt  bi 3 DEIt  bi 4UI t  bi 5UPRt  bi 6UTSt ]  eit

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Macroeconomic Factor Models

• Burmeister, Roll, and Ross (1994)

– Analyzed the predictive ability of a model based
on the following set of macroeconomic factors.
• Confidence risk
• Time horizon risk
• Inflation risk
• Business cycle risk
• Market timing risk

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 Exercise
• Suppose that two factors, surprise in inflation (Factor 1) and
surprise in GDP growth (Factor 2), explain returns. According to
the APT, an arbitrage opportunity exists unless
E  R p   R f  1 p ,1  2  p ,2

• Estimate the three parameters of the model with the following

assumptions on the three well-diversified portfolios, J, K, and L:

Portfolio Expected return Sensitivity to Sensitivity to

inflation factor GDP factor

J 0.14 1.0 1.5

K 0.12 0.5 1.0
L 0.11 1.3 1.1 45

Fundamental Factor Models

• In fundamental factor models, the factors are stated as returns

rather than return surprises in relation to predicted values, so
they do not generally have expected values of zero. This
approach changes the meaning of the intercept, which is no
longer interpreted as the expected return.
• Factor sensitivities are also interpreted differently in most
fundamental factor models. In fundamental factor models, the
factor sensitivities are attributes of the security. An asset’s
sensitivity to a factor is expressed using a standardized beta:

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 Fundamental Factor Models

• In fundamental factor models, the factors are stated as returns

rather than return surprises in relation to predicted values, so
they do not generally have expected values of zero. This
approach changes the meaning of the intercept, which is no
longer interpreted as the expected return.
• Factor sensitivities are also interpreted differently in most
fundamental factor models. In fundamental factor models, the
factor sensitivities are attributes of the security. An asset’s
sensitivity to a factor is expressed using a standardized beta:

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Fundamental Factor Models

• A second distinction between macroeconomic multifactor

models and fundamental factor models is that with the former,
we develop the factor (surprise) series first and then estimate
the factor sensitivities through regressions. With the latter, we
generally specify the factor sensitivities (attributes) first and
then estimate the factor returns through regressions.
• Financial analysts use fundamental factor models for a variety
of purposes, including portfolio performance attribution and
risk analysis.

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Fama-French Three-Factor Model

• SMB = Small Minus Big (firm size)

• HML = High Minus Low (book-to-market
ratio - Value)
• Are these firm characteristics correlated with
actual (but currently unknown) systematic risk
factors?
rit   i   iM RMt   iSMB SMBt   iHML HMLt  eit

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Factor Models in Return Attribution

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1. Determine the manager’s investment mandate and his actual investment
style.
2. Evaluate the sources of the manager’s active return for the year
3. What concerns might Service discuss with the manager as a result of the
return decomposition?
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Factor Models in Risk Attribution

 Active risk can be represented by the standard deviation of
active returns. A traditional term for that standard deviation
is tracking error (TE).
 Tracking risk is a synonym for tracking error that is
often used in the CFA Program curriculum. We will use the
abbreviation TE for the concept of active risk and refer to
it usually as tracking error:

 Information Ratio:

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Factor Models in Risk Attribution

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Factor Models in Portfolio Construction
 Passive management. In managing a fund that seeks to
track an index with many component securities, portfolio
managers may need to select a sample of securities from
the index. Analysts can use multifactor models to replicate
an index fund’s factor exposures, mirroring those of the
index tracked.
 Active management. Many quantitative investment
managers rely on multifactor models in predicting alpha
(excess risk-adjusted returns) or relative return (the return
on one asset or asset class relative to that of another) as
part of a variety of active investment strategies. In
constructing portfolios, analysts use multifactor models to
establish desired risk profiles.
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Factor Models in Portfolio Construction

 Rules-based active management (alternative indexes or
factor investing). These strategies routinely tilt toward
such factors as size, value, quality, or momentum when
constructing portfolios. As such, alternative index
approaches aim to capture some systematic exposure
traditionally attributed to manager skill, or “alpha,” in a
transparent, mechanical, rules-based manner at low cost.
Alternative index strategies rely heavily on factor models
to introduce intentional factor and style biases versus
capitalization-weighted indexes.

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LAB Section: Factor Analysis using the
CAPM and Fama-French Factor models
 Use the file:
lab_201_CAPM FF.ipynb
lab_202_Style Analysis.ipynb

 Data files:
ind30_m_vw_rets.csv

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