Journal of Risk

Risk.net

A factor-based risk model for multifactor investment strategies

Frédéric Abergel, Benoit Bellone and François Soupé

  • Risk models must be adapted to multifactor investment strategies.
  • A cross-sectional risk model based a small number of style factors and macro sectors is proposed.
  • The model-based covariance structure accurately accounts for the stocks’ characteristics.
  • The portfolio construction optimization program is analyzed in detail.

This paper presents a novel, practical approach to risk management for multifactor equity investment strategies. Our approach lies in the construction of a cross-sectional risk model using the stock return betas and a small number of style factors and macro-sector indicator functions as explanatory variables in a cross-sectional regression. The model leads to a covariance structure that incorporates in an intuitive fashion both the stocks’ characteristics and good conditioning properties that lead to robust optimization problems. Various portfolio constructions are analyzed in detail, and some concrete examples are provided.

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