Measuring Factor Exposures: Uses and Abuses

36 Pages Posted: 22 Sep 2016

See all articles by Ronen Israel

Ronen Israel

AQR Capital Management, LLC

Adrienne Ross

AQR Capital Management, LLC

Date Written: September 19, 2016

Abstract

A growing number of investors have come to view their portfolios (especially equity portfolios) as a collection of exposures to risk factors. The most prevalent and widely harvested of these risk factors is the market (equity risk premium); but there are also others, such as value and momentum (style premia).

Measuring exposures to these factors can be a challenge. Investors need to understand how factors are constructed and implemented in their portfolios. They also need to know how statistical analysis may be best applied. Without the proper model, rewards for factor exposures may be misconstrued as alpha, and investors may be misinformed about the risks their portfolios truly face.

This paper should serve as a practical guide for investors looking to measure portfolio factor exposures. We discuss some of the pitfalls associated with regression analysis, and how factor design can matter a lot more than expected. Ultimately, investors with a clear understanding of the risk sources in an existing portfolio, as well as the risk exposures of other portfolios under consideration, may have an edge in building better diversified portfolios.

Keywords: Risk factors, regression, beta, portfolio exposures, diversification

Suggested Citation

Israel, Ronen and Ross, Adrienne, Measuring Factor Exposures: Uses and Abuses (September 19, 2016). Journal of Alternative Investments, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2841037 or http://dx.doi.org/10.2139/ssrn.2841037

Ronen Israel

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Adrienne Ross (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

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