The Characterstics of Factor Portfolios

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A key to deeper understanding of factor models lies in the concept of factor-mimicking portfolios, whose returns exactly replicate the payoffs to the factors.  Factor-mimicking portfolios can be used to generate real-time factor returns and in principle could serve as the basis for exchange traded funds for capturing passive alpha or hedging risk.  Simple factor portfolios are obtained by considering each factor in isolation, whereas pure factor portfolios are constructed by treating all factors jointly.  In this paper, we derive the holdings of simple factor portfolios for the World factor, as well as for countries, industries, and styles.

Author: Jose Menchero, Ph.D., CFA, MSCI

A key to deeper understanding of factor models lies in the concept of factor-mimicking portfolios, whose returns exactly replicate the payoffs to the factors.  Factor-mimicking portfolios can be used to generate real-time factor returns and in principle could serve as the basis for exchange traded funds for capturing passive alpha or hedging risk.  Simple factor portfolios are obtained by considering each factor in isolation, whereas pure factor portfolios are constructed by treating all factors jointly.  In this paper, we derive the holdings of simple factor portfolios for the World factor, as well as for countries, industries, adn styles.

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