2024 Curriculum CFA Program Level II Portfolio Management and Wealth Planning

Introduction

As used in investments, a factor is a variable or a characteristic with which individual asset returns are correlated. Models using multiple factors are used by asset owners, asset managers, investment consultants, and risk managers for a variety of portfolio construction, portfolio management, risk management, and general analytical purposes. In comparison to single-factor models (typically based on a market risk factor), multifactor models offer increased explanatory power and flexibility. These comparative strengths of multifactor models allow practitioners to

• build portfolios that replicate or modify in a desired way the characteristics of a particular index;
• establish desired exposures to one or more risk factors, including those that express specific macro expectations (such as views on inflation or economic growth), in portfolios;
• perform granular risk and return attribution on actively managed portfolios;
• understand the comparative risk exposures of equity, fixed-income, and other asset class returns;
• identify active decisions relative to a benchmark and measure the sizing of those decisions; and
• ensure that an investor’s aggregate portfolio is meeting active risk and return objectives commensurate with active fees.

Multifactor models have come to dominate investment practice, having demonstrated their value in helping asset managers and asset owners address practical tasks in measuring and controlling risk. We explain and illustrate the various practical uses of multifactor models.

We first describe the modern portfolio theory background of multifactor models. We then describe arbitrage pricing theory and provide a general expression for multifactor models. We subsequently explore the types of multifactor models and certain applications. Lastly, we summarize major points.

Learning Outcomes

The member should be able to:

• describe arbitrage pricing theory (APT), including its underlying assumptions and its relation to multifactor models;
• define arbitrage opportunity and determine whether an arbitrage opportunity exists;
• calculate the expected return on an asset given an asset’s factor sensitivities and the factor risk premiums;
• describe and compare macroeconomic factor models, fundamental factor models, and statistical factor models;
• explain sources of active risk and interpret tracking risk and the information ratio;
• describe uses of multifactor models and interpret the output of analyses based on multifactor models;
• describe the potential benefits for investors in considering multiple risk dimensions when modeling asset returns.

Summary

In our coverage of multifactor models, we have presented concepts, models, and tools that are key ingredients to quantitative portfolio management and are used to both construct portfolios and to attribute sources of risk and return.

• Multifactor models permit a nuanced view of risk that is more granular than the single-factor approach allows.
• Multifactor models describe the return on an asset in terms of the risk of the asset with respect to a set of factors. Such models generally include systematic factors, which explain the average returns of a large number of risky assets. Such factors represent priced risk—risk for which investors require an additional return for bearing.
• The arbitrage pricing theory (APT) describes the expected return on an asset (or portfolio) as a linear function of the risk of the asset with respect to a set of factors. Like the CAPM, the APT describes a financial market equilibrium; however, the APT makes less strong assumptions.
• The major assumptions of the APT are as follows:
Asset returns are described by a factor model.
With many assets to choose from, asset-specific risk can be eliminated.
Assets are priced such that there are no arbitrage opportunities.
• Multifactor models are broadly categorized according to the type of factor used:
Macroeconomic factor models
Fundamental factor models
Statistical factor models
• In macroeconomic factor models, the factors are surprises in macroeconomic variables that significantly explain asset class (equity in our examples) returns. Surprise is defined as actual minus forecasted value and has an expected value of zero. 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 and are meant to be uncorrelated.
• 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 are book-value-to-price ratio, market capitalization, price-to-earnings ratio, and financial leverage.
• In contrast to macroeconomic factor models, in fundamental models the factors are calculated as returns rather than surprises. In fundamental factor models, we generally specify the factor sensitivities (attributes) first and then estimate the factor returns through regressions. In macroeconomic factor models, however, we first develop the factor (surprise) series and then estimate the factor sensitivities through regressions. The factors of most fundamental factor models may be classified as company fundamental factors, company share-related factors, or macroeconomic factors.
• 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.
• Multifactor models have applications to return attribution, risk attribution, portfolio construction, and strategic investment decisions.
• A factor portfolio is a portfolio with unit sensitivity to a factor and zero sensitivity to other factors.
• Active return is the return in excess of the return on the benchmark.
• Active risk is the standard deviation of active returns. Active risk is also called tracking error or tracking risk. Active risk squared can be decomposed as the sum of active factor risk and active specific risk.
• The information ratio (IR) is mean active return divided by active risk (tracking error). The IR measures the increment in mean active return per unit of active risk.
• Factor models have uses in constructing portfolios that track market indexes and in alternative index construction.
• Traditionally, the CAPM approach would allocate assets between the risk-free asset and a broadly diversified index fund. Considering multiple sources of systematic risk may allow investors to improve on that result by tilting away from the market portfolio. Generally, investors would gain from accepting above average (below average) exposures to risks that they have a comparative advantage (comparative disadvantage) in bearing.