factor investing Flashcards
a factor
a variable or characteristic with which individual asset returns are correlated
any variable that is believed to be valuable in ranking stocks for investment and in predicting future returns or risk
rewarded factors
factors show to be positively associated with a long-term return premium
most common rewarded factors
size
value
momentum
quality
unrewarded factors
factors that do not offer premium
factor based strategy
aims to identify significant factors that can predict future stock returns and to construct a portfolio that tilts towards such factors
equity style rotation strategies
subcategory of factor investing
based on the belief that different factors work well during some periods but not as much in others
allocate to stock baskets representing each of these styles when a particular style is expected to offer a positive excess return compared to the benchmark
more quantitative than qualitative
the most important test for a factor
the smell test
the smell test
does the factor make intuitive sense?
there needs to be justification for the factor’s efficacy
the most traditional and widely used method for implementing factor-based portfolios
the hedged portfolio approach
Fama and French
the hedged portfolio approach
after choosing the factor to be scrutinized and ranking the investable stock universe by that factor, investors divide the universe into groups referred as quantiles to form quantile portfolios
hedged portfolio by longing the best quantile and shorting the worst quantile
performance is tracked over time
drawbacks to the hedged portfolio approach
- information contained in the middle quantiles is not utilized
–> only the top and bottom
- it is implicitly assumed that the relationship between the factor and future stock returns is linear, which may not be the case
- portfolios built using this approach tend to be concentrated in specific stocks
- requires managers to short stocks
- not a pure factor portfolio because it has significant exposure to other risk factors (most important)
factor tilting portfolio
long-only portfolio with exposures to a given factor can be built with controlled tracking error
tracks a benchmark index closely but also provides exposures to the chosen factor
similar to an enhanced index strategy
a factor mimicking portfolio
a theoretical implementation of a pure factor portfolio
invest in almost single stock, so very expensive to trade
style factor (size)
fundamental characteristics of underlying companies
value factors
checking the P/E and earnings
book to market
can also be based on other fundamental performance metrics of a company
