The structure of multifactor equity risk models

Abstract

A number of commercial risk models have been available to institutional fund managers for the last two decades, and while there has been considerable discussion as to their different choices of factors, their different methods of construction have rarely been questioned or compared. This paper seeks to lay out the important choices to be made in building linear, multi-factor risk models. Its key insight is simply that stock risk models are not built for stock risk analysis, but for portfolio risk analysis, so that the usefulness of any of the various alternative methods of model construction needs to be evaluated at the portfolio level, not at the single stock level. The paper includes a brief review of the more well-known risk models, showing how they fit into the framework discussed, and concludes by looking ahead to the development of customised, hybrid risk models, designed to match specific investment processes.