Multifactor Risk Models and Portfolio Construction and Management

The previous chapter introduced the reader to Markowitz mean-variance analysis and the Capital Asset Pricing Model. The cost of capital calculated in Chap. 10 assumes that the cost of equity is derived from the Capital Asset Pricing Model and its corresponding beta or measure of systematic risk. The Gordon Model, used for equity valuation in Chap. 8 , assumes that the stock price will fluctuate randomly about its fair market value. The cost of equity is dependent upon the security beta. In this chapter, we address the issues inherent in a multi-beta or multiple factor risk model. The purpose of this chapter is to introduce the reader to multifactor risk models. There are academic multifactor risk models, such as those of Cohen and Pogue (1967), Farrell (1974), Stone (1974), Ross (1976), Roll and Ross (1980), Dhrymes et al. (1984, 1985), and Fama and French (1992, 1995, 2008). There are practitioner multifactor risk models, such as Barra, created during the 1973–1979 time period, Advanced Portfolio Technologies (APT), created in 1987, and Axioma, created in the late 1990s, which gained practitioner acceptance in the 2000–2019 time period. The former academicians who created these practitioner models are Barr Rosenberg, Andrew Rudd, John Blin, Steve Bender, and Sebastian Ceria. We will introduce the reader to the practitioner models and their academician creators in this chapter. Which models are best? We, at McKinley Capital Management, MCM, have tested these models. None of the models are perfect, but the models are generally statistically significant when the statistically significant tilt variables of Chap. 14 are used for portfolio construction. In this chapter, we discuss the MCM Horse Races of the 2010–2019 time period to test stock selection within the commercially available multifactor risk models. We trace the development of the Barra, APT, and Axioma commercially available risk models. We conclude with an update of US and non-US portfolios for the 1996–2020 time period. Long-term portfolio strategies have worked for the past 24 years, not just out-of-sample, but post publication of Bloch et al. (1993) with the Axioma Statistical Risk Model.