Risk Factors and Tracking Portfolios

Tracking portfolios

Tracking Portfolio: A portfolio assembled with securities that will replicate a specific risk profile.

• Tracking portfolios commonly mirror an expected benchmark index, such as an index of global large capitalization stocks.

• The theoretical construction of a tracking portfolio done through multifactor modeling is done by setting each factor sensitivities equal to the factor sensitivities of the benchmark.

• For example, if a mid cap stock index is made of 500 stocks, then the portfolio manager can create a tracking portfolio through a sample of the 500 stocks that has a collective risk factor sensitivity equal to that of the index.

• Tracking portfolios can be used for hedging/risk management.

• For example, a portfolio manager may want to temporarily decrease the portfolio's risk exposure to a certain asset class (stocks, bonds, commodities, etc.) or sub-asset class (small cap stocks, high yield debt, gold, etc.) sector.

Investor Risk Tolerance and Multifactor Models

• Different individual investors will have different individual degrees of ability to bear risk.
• Therefore, not all investors should hold the same portfolio.
• A multifactor model can be used to design the optimal portfolio for the individual investor by overweighting and underweighting exposure different asset classes in the portfolio.
• Investors can increase their relative exposure to certain risk factors whenever their tolerance for the priced risk exceeds that of the average investor.

Fundamental Multifactor Models

Whereas APT is usually associated with economic risk exposures such as GDP growth, inflation, and interest rates, multifactor models can also be applied to a security's fundamental valuation traits following the multiple variable regression technique.

Standardized Beta = (Fundamental stock i - Fundamental avg stock ) / σ fund all stocks

• The standardized beta scales a fundamental value metric across all stocks.
• This formula can be applied to any stock fundamental valuation metric, such as price to earnings ratio.

Factor Models and the Sources of Risk and Return