Chapter 4

Factor-Based Equity Portfolio Construction and

Performance Evaluation
Introduction
 Factor models have become a key driver for the use of analytics in
portfolio construction and risk management. Equity investment
strategies are often based on factor groupings , where the factors
can include value, growth, volatility, and liquidity.
 Identifying and incorporating such factors in the investment process
requires deeper comfort with analytical techniques than has been
traditionally required.
 This chapter describes in detail :
 how factors enter into the process for selecting equity investments,
portfolio construction.
 list of typical factors used in equity portfolio construction and how factors
are used for stock screening, portfolio construction, stress testing.
Equity Factors Used in Practice
 12.1.1 Fundamental Factors :
 Many of these financial ratios are correlated as they represent
similar characteristics of the company, so it is not necessary to
consider all.
 Valuation or value factors can include market capitalization, price-to-
earnings (P/E) ratio, price-to-book (P/B) ratio, price-to-sales (P/S)
ratio, dividend yield (D/P), price-to-cash-flow (P/CF) ratio
 For example, it has been observed that small-cap stocks outperform
large-cap stocks over the long term. Some studies claim that
companies with high dividend yields and low P/B, P/S, P/CV, tend to
outperform stocks with low dividend yields and high P/B, P/S, P/CV,
ratios.
 Growth potential or growth factors can include price-to-earnings-to
growth (PEG) ratio, advertising expenditure- to-sales ratio, and
capital-expenditure-to-sales ratio. PEG ratio, for example, can be
considered in conjunction with P/E ratio.
Equity Factors Used in Practice
 12.1.1 Fundamental Factors :
 Operating efficiency factors can include total asset turnover (TAT)
ratio, equity turnover (ET) ratio, and fixed-asset turnover (FAT)
ratio. For example, a high IT ratio is an indication that the company’s
products are in high demand.
 Solvency factors can include debt-to-equity (D/E) ratio, interest
coverage ratio (ICR), current (CUR) ratio, quick ratio (QR), and cash
ratio (CR). For example, a high D/E ratio generally can mean higher
risk of financial distress. A high CUR ratio (the ratio of current
assets to current liabilities) generally indicates high liquidity.
Equity Factors Used in Practice
 12.1.1 Fundamental Factors :
 Operating profitability factors can include gross profit margin (GPM),
operating profit margin (OPM), net profit margin (NPM), return on
total capital (ROTC), and return on total equity (ROTE).
 Liquidity factors such as trading turnover (TT) give an indication for
how easy it is to trade the stock. Higher liquidity generally translates
into higher returns because investors are more willing to hold liquid
stocks.
Equity Factors Used in Practice ( Continued)
 12.1.2 Macroeconomic Factors
 Asset Pricing Theory, the theory that gave escalation to the spread
of factor models in industry, was based on macroeconomic factors
of asset returns such as inflation, real interest rates, and risk
premiums.
Equity Factors Used in Practice ( Continued)
 12.1.3 Technical Factors
 Technical factors are constructed based on information about past
prices, trading volume, and bid–ask spreads.
 Perhaps the most widely used technical factor is momentum, which
can, for example, be measured as the stock return over the past
year.
 Portfolio managers use technical factors in order to take into
consideration possible short-term effects on the stock price.
Equity Factors Used in Practice ( Continued)
 12.1.4 Additional Factors
 analysts’ forecasts, social responsibility factors such as employee
relations, environment, or human rights.
Stock Screens
 Equity investment managers use stock screens to rank stocks in the
investment universe according to one or multiple criteria in such a
way that it makes it possible to differentiate between desirable and
undesirable investments.
1. A famous example of a screen is the Peter Lynch growth screen,
which identifies companies that are generating strong growth
relative to their current market valuation. Two of the main criteria
used are a P/E ratio that is less than the industry average and a
PEG ratio that is less than 1.0.
2. Stock screens are not the most sophisticated method for
portfolio construction, but they are intuitive and are a good
starting point include z-score rankings.
Stock Screen ( Continued)
 In the context of stock screens, the z-score of a company for a
particular metric gives a sense of the outperformance or
underperformance of the company relative to the other companies
in the investment universe according to that metric.

Company A’s z-score is

Individual P/E ratio – mean P/E ratio = 23 - 25 = -0.15

Standard deviation of P/E ratios 13
Stock Screen ( Continued)
 This means that company A’s P/E ratio is lower than the average P/E
ratio of the 10 companies under consideration by 0.15 standard
deviations. Because a low P/E ratio is an indication of company
strength, the companies with negative z-scores of the 10 companies
in the sample may be considered more desirable than the companies
with positive z-scores.
 A z-score is helpful also when a portfolio manager would like to use
multiple criteria to rank stocks at once. These criteria are often
expressed through metrics of different magnitudes.
Stock Screen ( Continued)
 Calculating the z-scores allows the manager to combine rankings
and come up with an aggregate score for a particular company. For
example, suppose that company A’s momentum z-score (within the
investment universe of 10 stocks) is –1.35, and its size z-score is
2.50.
 likes stocks with low P/E ratio but large market capitalization and
high momentum.
 If the portfolio manager considers all three factors (P/E ratio,
momentum, and size) equally important, he can weigh each z-score
by 1/3.
1 1
( -zA,P/E + zA,Size + zA,Momentum ) = ( - (-0.15) + (2.50) + (-1.35))
3 3
= 0.43
Stock Screen ( Continued)
 portfolio managers sometimes group similar factors together, and
calculate aggregate z-scores within each factor group before
computing an overall z-score.
 Valuation metrics (Price-to-Earnings [P/E] ratio, Return-on-Equity
[ROE], Price-to-Book [P/B] ratio, Price-to-Sales [P/S] ratio).
 Profitability metrics (Gross Profit Margin [GPM]), financial
Soundness metrics Debt-to-Equity [D/E] ratio).
 Risk metrics (previous 12 month’s standard deviation of returns,
standard deviation of cash flows).
 Technical or momentum metrics (previous one month’s return,
previous six months’ return, previous 12 months’ return, return on a
major index such as the S&P 500).
Stock Screen ( Continued)
 Grouping metrics of performance together has several advantages.
First, provides a more complete picture than a single metric.
 Second, an investment manager can change the relative weights of
the different groups of factors depending on his views of how the
market ranks these factors at a particular moment in time.
 Stock screens have the drawback of providing only a relative ranking
of stocks without an actual estimate of the expected stock return.
Portfolio Selection
 12.3.1 Ad-Hoc Portfolio Selection
 For portfolio managers who manage relative to a benchmark, a
simplistic approach to duplicating the return on the benchmark is to
select the largest holdings in the benchmark and keep them in the
portfolio.
 For example, if the portfolio manager would like to hold 30 stocks,
the 30 stocks with the
 1- largest weights from the benchmark can be included.
 2- according to their aggregate z-scores.
Portfolio Selection (Continued)
 12.3.2 Stratification
 let us consider the following example: Suppose a portfolio manager
would like to match the industry composition factor of the
benchmark. Suppose there are 10 industries represented in the
benchmark.
 A passive manager selects a few stocks from each of these 10
industries in such a way that the relative weight of all the stocks in a
particular industry in his portfolio is the same as the relative weight
of the industry in the benchmark.
 A manager following an enhanced indexing strategy (active) may
choose to tilt the portfolio to an industry that is expected to
outperform, and increase the relative percentage of stocks from that
industry in the portfolio.
Portfolio Selection (Continued)
 The passive manager is the same as the manager would like to take
a second factor into consideration, such as P/E ratio.
 A manager following an enhanced indexing strategy may tilt the
portfolio by selecting a percentage of the portfolio from some
buckets that is intentionally higher or lower than the percentage
they represent in the benchmark.
Portfolio Selection (Continued)
Exhibit 12.1 Small P/E Medium P/E Large P/E
Information
... ... ...
Technology
Consumer
... ... ...
discretionary
Energy ... ... ...
Healthcare ... ... ...
Telecommunication ...
... ...
Service
Industrials ... ... ...
Financials ... ... ...
Consumer staples ... ... ...
Utilities ... ... ...
Materials ... ... ...
Clear picture of how risk is reduced relative to not using the method
Risk Decomposition
 understanding the sources of risk in the portfolio. In practice, this
reduces to estimating to what extent the variability in different
factors contributes to the variability in portfolio returns.
 The process of breaking down a particular measure of portfolio risk
into contributions by factors is referred to as portfolio risk
decomposition.
 the active risk will be measured as the variance of the deviations of
the portfolio returns from the benchmark returns that is, by the
square of the tracking error.
 We begin by decomposing portfolio active risk into risk contributed
by three sources: specific (variability related to individual securities),
style (variability related to factors in the style category,), and
industry (variability related to the performance of various industries
represented in the portfolio).
Exhibit 12.2 portfolio active risk decomposition
Stress Testing
 Stress testing is another important component of a robust portfolio
risk management strategy.
 It involves subjecting the portfolio to theoretical scenarios to see
how the portfolio would perform if such scenarios were to occur.
 Stress testing can involve factor shocks or extreme scenarios.