Research from MSCI's Jose Menchero was recently published in The Journal of Performance Measurement. This paper provides an intuitive foundation for understanding and interpreting factor models. It shows every factor can be represented by a factor-mimicking portfolio, whose return exactly replicates the payoff to the factor. Pure factors provide a way of placing surgical bets and disentangling the often confounding effects of multi-collinearity. Read this paper.Abstract:
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. We also discuss the characteristics of pure factor portfolios and how differences between simple and pure factor portfolios arise due to collinearity between factors.
We introduce several intuitive measures of collinearity in factor models and present their empirical distributions in the context of a global equity model. Finally, we describe how collinearity can be reduced through factor rotation and discuss the interpretation of such factors.
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