The Fundamentals of Fundamental Factor Models

Abstract

Fundamental factor risk models have been used in equity portfolio management and risk management for decades now. There persists, however, the notion that fundamental factor models are “quantitative” models that are divorced from fundamental analysis, the realm of traditional equity analysts. This perception is inaccurate in that the basic building blocks of analysts and factor modelers are in fact similar; both try to identify microeconomic traits that drive the risk and returns of individual securities. The differences between fundamental factor models and fundamental analysis lie not in their ideology but in their objectives. The objective of the fundamental analyst is to forecast return (or future stock values) for a particular stock. The objective of the fundamental factor model is to forecast the fluctuation of a portfolio around its expected return. Most importantly, the factor model captures the interaction of the firm's microeconomic characteristics at the portfolio level. This is important because as names are added to the portfolio, company-specific returns are diversified away, and the common factor (systematic) portion becomes an increasingly larger part of the portfolio risk and return. Fundamental factor models are in fact complementary as opposed to antithetical to traditional security analysis.