Factor portfolio is a diversified portfolio of several different stocks that have varying levels of risk exposure, such as changes in inflation, interest rates and/or oil prices. By blending the right risk factors (also known as premiums), an investor can produce a more diversified portfolio that has a better chance to outperform the market. A portfolio is a spread of investment products.
The stocks that are picked in a factor portfolio are determined so that it has a beta of 1.0 on one factor and a beta of 0 on any other factors. It uses countries, industries, and styles as explanatory variables, and stocks are assigned an exposure of either 0 or 1.
A beta of 1 means that the security’s price will move with the market. A beta of lower than 1 means that the security will be less volatile than the market. A beta of greater than 1 means that the security’s price will be more volatile than the market.
This trading strategy typically includes both long and short trading positions.
There are two methods of creating factor-mimicking portfolios:
Simple factor portfolios – result from univariate regressions that effectively treat the factor in isolation.
Pure factor portfolios – result from multivariate regressions that simultaneously consider all factors.
“A well-diversified portfolio constructed to have a beta of 1.0 on one factor and a beta of zero on any other factors.”
The secret, say experts, is to select factors that have a long history of delivering strong results and the minimum (or even negative) of correlations with each other. Then, when one factor goes bad, there is a good chance that one of the others is keeping things healthy.