Best Practices in

Factor-Based Analytics
Phil Martinelle
Axioma, Inc.
November 7, 2016

Introduction
As a portfolio manager, have you ever been surprised by a bad return period? Or wondered if there is a
better way to identify the risks in your portfolio? Have you wanted to look for sources of return beyond sector
breakdowns? If so, this paper will provide an overview into how you can address these questions and more.

Most managers decompose their portfolio return at the sector and asset levels. While this provides important
insight, it does not capture the complete returns decomposition, leaving a lot of valuable information out of their
analysis. And many managers monitor their portfolio’s historical tracking error – they may even be required to
periodically report on it. Unfortunately, knowing historical tracking error does not always correlate with what the
tracking error will be in the next period. And many managers struggle to identify where their tracking error came
from historically, before even considering where it is likely to come from in the future.

This paper will help guide you through decomposing returns and tracking error, otherwise known as Active
Risk, and will provide a concise overview of Axioma’s tools to better understand return and predict and manage
risk. We will do this with a case study analysis of a real-life portfolio.

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 Overview of risk
Let’s begin with an overview of risk in general and some ways it is measured. Most people think of risk as
an exposure to danger or, more specifically, the probability of a negative occurrence. For instance, someone
might consider the “risk,” or probability, of not surviving a skydiving trip. In this case, calculating this risk is fairly
straightforward, assuming the data is available, by dividing the number of unsuccessful skydiving trips by the
total number of skydiving trips.

When measuring investment risk, the calculation is somewhat more complicated. Instead of a simple division,
we look at standard deviation. Standard deviation also employs a probability, yet it is a probability band around a
mean. To give an example, let’s say we have two sets of portfolio returns. Figure 1 shows two different portfolios
returns versus the same benchmark, monthly, for a year. They each have an average monthly excess return of
0.19%. By looking a bit deeper, we can see that Portfolio A is clearly tracking the benchmark much closer with
a monthly high excess return of 0.80% and low of -0.40%, while Portfolio B has a monthly high excess return of
2.30% and low of -2.10%. Obviously if the investor is trying to track somewhat closely to the benchmark, then
Portfolio A is significantly less risky than Portfolio B. As expected, this manifests itself in the observed annualized
standard deviation (multiply the monthly standard deviation by the square root of 12 to annualize). Portfolio A
shows 1.34% observed annualized standard deviation while Portfolio B shows a much larger 4.86%. In other
words, for Portfolio A we would expect that with 68% confidence the annual excess return will be within -1.15%
and 1.53%. Portfolio B’s annual excess return risk has a much wider band, from -4.67% to 5.05%. Again the
variability of returns shows that Portfolio A is less risky than Portfolio B, since we can be confident that Portfolio
A’s returns will display less variance then Portfolio B; and thus that the probability of an extreme loss is less with
Portfolio A than with Portfolio B. We call the standard deviation of excess return “Active Risk.”

Figure 1
Portfolio A Benchmark Excess Return Portfolio B Benchmark Excess Return
0.10 -0.40 0.50 -1.75 -0.40 -1.35
-0.10 -0.20 0.10 -1.50 -0.20 -1.30
-0.60 -0.50 -0.10 0.80 -0.50 1.30
0.00 -0.10 0.10 -1.30 -0.10 -1.20
-0.80 -0.40 -0.40 -0.80 -0.40 -0.40
0.90 1.20 -0.30 -0.90 1.20 -2.10
0.40 0.50 -0.10 2.80 0.50 2.30
-0.20 -1.00 0.80 -0.70 -1.00 0.30
-0.40 -1.00 0.60 0.30 -1.00 1.30
-1.10 -1.20 0.10 -0.70 -1.20 0.50
0.80 0.00 0.80 2.25 0.00 2.25
-1.00 -1.20 0.20 -0.50 -1.20 0.70
Average 0.19 Average 0.19
High 0.80 High 2.30
Low -0.40 Low -2.10
St Deviation 0.39 St Deviation 1.40
Annualized St Dev 1.34 Annualized St Dev 4.86

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 Factors
Thus far we have looked at observed data and calculated some metrics that help us better understand the
data and its riskiness. This is very important and instructive analysis, yet it does not tell us where risks lie. For
instance, in Figure 1 we can clearly see Portfolio B is riskier than Portfolio A. What we don’t know is why
Portfolio B is riskier.

In order to determine that, we need to look at the portfolio’s risk factors, or what are simply called factors.
Factors are common and observable characteristics of every security. For example, every security will have a
price-to-earnings ratio and will belong to a certain industry. We will look into this concept a bit more below.

Let’s take health insurance, a non-financial example, to help better understand risk factors. We will look at two
potential risk factors: smoking and peanut butter brands. We know that smoking can lead to lung cancer, which
is expensive to treat. Conversely, we would imagine that the brand of peanut butter someone eats does not
affect their likelihood of contracting an illness that requires expensive treatment. Therefore, when deciding how
much to charge for a policy, we would expect an insurance provider to inquire if an individual smokes tobacco
products but not ask if the individual eats Jif® or Skippy® peanut butter. What we would say then is that the
explanatory power of the factor “smoker” is much higher than that of “peanut butter brand” when it comes to
predicting if an individual will require expensive treatment, with the “peanut butter brand” factor probably having
no explanatory power at all.

Factor-Based Regression Analysis

Using a statistical method called regression, we are able to look at a list of potential factors to determine which
ones are best able to explain observed return and then create an equation to model the observed return. To
do this, we list in matrix form the exposure each security has to each factor and regress that matrix of security-
level exposures against the vector of each security’s return. The complete list of securities that are used in the
regression is called the estimation universe. In this case, we use an estimation universe of roughly 3,000 U.S.
securities. Exposures are the observable characteristics, such as the book-to-price ratio, of each security. Once
we normalize that data (by subtracting the universe mean and dividing by the universe standard deviation), we
call that factor “Value.”

Once the regression has been run for day X, it will produce a set of slopes (or factor returns) for each factor,
along with a metric called a T-stat, that tells how useful that factor is to explaining the overall observed return.
Based on the T-stats, among other metrics, we can determine which factors to keep because they have more
explanatory power (just like the “smoking factor” in the health insurance example) and which ones to remove
(the “peanut butter brand” factors). Ultimately what this means in practice is that the final regression model
structure will provide a slope for each factor, for each day. By multiplying a security’s exposure to each factor by
the factor return, we are able to determine the factor’s contribution to the security’s return. We can sum all these
contributions to produce the model-expected security’s return for day X. And taken at the portfolio factor level,

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 we can sum the factor contributions in a portfolio to produce the model-expected portfolio return for day X. The
difference between the model’s expected return and the true holdings-based return is called selection or residual.

Next we take this new information and create the process to look at Predicted Active Risk. We should take a
moment to distinguish between two different definitions of Active Risk (and standard deviation in general). Our
portfolio example in Figure 1 looks at Observed Active Risk. This means that we take the observed excess
returns for the previous X dates and then calculate a standard deviation of the excess returns. Managers
will commonly call this the portfolio’s historical tracking error. This is an important calculation when looking
at portfolio risk, although it does not tell us why the risk is what it is. There is another concept that is called
Predicted Active Risk. This method is somewhat different in that it takes the historical regression-produced
factor returns and creates a covariance matrix. One can think of this as an n x n matrix where the n’s are each
factor. The diagonal of this matrix is called the variance, and this is the volatility of the individual factor returns
over the last Y days. The off-diagonal elements are the covariance terms, and this shows how all the different
factor return pairs vary together. The important thing to remember is that the covariance matrix constructed
using historical factor returns is used to produce a forward looking or Predicted Active Risk (as opposed to
a simple Historical or Observed Active Risk), and it has the benefit of being able to show how each factor
contributed to risk. This Predicted Active Risk will be the basis of our overall discussion.

Aggregating the sources of Active Risk is slightly more complicated than aggregating returns. Based on the
matrix algebra employed above, each security will have a Marginal Contribution to Active Risk (MCAR). By
multiplying the net weight of each security (the security’s weight in the portfolio minus the same security’s weight
in the benchmark) by each security’s MCAR, we will receive each security’s contribution to Predicted Active Risk.
If we sum all of the securities’ contributions, we will arrive at the portfolio’s total Predicted Active Risk.

Factor Discovery
Through significant research, we have uncovered a list of factors that we use in our risk model. (A detailed
overview of the risk model is presented in the Appendix in the attached US4 Factsheet.) These factors help us
better understand why one portfolio is riskier than another or, as is more often the case, where the sources of
return and risk lie in a single portfolio, versus a benchmark.

Dividend Yield Market Sensitivity

Earnings Yield Medium Term Momentum
Exchange Rate Sensitivity Midcap
Growth Profitability
Industry classification Short Term Momentum
Leverage Size
Liquidity Value
Volatility

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 Use Case
Now that we have identified the factors that will be used to better understand the sources of risk and return,
we can use a sample portfolio to illustrate the concepts. Our sample portfolio holds roughly 35 assets,
benchmarked against the Russell 1000 Growth Index for a one-year period from June 2015 to June 2016.

Portfolio Performance
Below in Figure 2, we see a high-level snapshot of the full-period return decomposition. The summary table
shows the portfolio returned -8.00% while the benchmark returned 2.97%, leading to a negative excess return
of -10.97%. The Risk column shows the observed annual standard deviation of returns, as opposed to the
model predicted risk that we will look at later. The portfolio clearly carries more observed risk at 23.39% versus
the benchmark of 17.34%, with an observed Active Risk of 10.11%. Clearly, the portfolio did not track the
benchmark very well over this period. We will look at why.

The Return Decomposition table shows the Active Return of -10.97% broken into Specific (-3.30%) and Factor
(-7.67%) return contributions. The Specific is the residual we noted earlier, and this is the segment of return that
the model cannot explain, which is more specifically the manager’s stock-picking ability. The Factor contribution
is the amount that the model can explain, and this is decomposed into the Style (-6.31%) and Industry (-1.37%)
contributions. The portfolio’s negative excess return was greatly influenced by the Style factor bets (which may
or may not have been intentional) and the manager’s skill at stock-picking, while the Industry bets provided a
somewhat smaller negative contribution.

Figure 2

With further digging, we uncover more information on why the portfolio performed so poorly. Figure 3, the
Contributors to Active Return by Style table, shows the Style factors sorted by their contribution to return. We
can see that summing all the contributions arrives at the -6.31% Style contribution we noted above.

The Average Weighted Exposure column shows the portfolio had a number of active bets, and some paid
off while some did not. The first one, Leverage, shows the portfolio was underexposed compared with the
benchmark by -0.55, which led to a positive contribution of 1.52%. Put another way, the portfolio benefitted

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 because it owned less-leveraged securities than the benchmark, and during this period less-leveraged
securities performed better than more highly leveraged securities. On the other side of the spectrum, the
portfolio was exposed to higher volatility securities than the benchmark by 0.2682 and during this period
lower volatility securities outperformed, which led to a large -3.62% contribution to return. The Profitability,
Growth, and Dividend Yield bets all negatively contributed to the portfolio’s excess return by large margins. The
management of this portfolio does not appear to incorporate Style factors, which significantly detracted from the
portfolio’s excess return.

Figure 3

We already looked at the Average Weighted Exposure at the factor level. Of course, averages and even totals
can be misleading. Since the attribution was run over a year (about 252 days), there might be some significant
movements over that period. There are a few ways we will dig into this.

Figure 4, the Common Factor Contributions table, shows the portfolio’s day-by-day Active Return in blue and
the portion of that which could be decomposed into Style, Industry, and Specific contributions. Looking at
Figure 4, we can see that the portfolio did a fair job of tracking the benchmark over the first six months, with a
midpoint Active Return around -2.5%. The second half of the year was marked by a quick two-month drop to
almost -16% and then a final four-month claw-back to get the portfolio to the -10.97% it ended with. Clearly,
something went quite badly over those two months.

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 Figure 4

Figure 5, the Style Contributions table, breaks the Style component into the 14 Style factors. The portfolio’s
active exposure to Volatility consistently provided a strong negative return, while Leverage consistently benefitted
active return. Interestingly, in black we can see that Market Sensitivity (Beta) started the period off with minimal
impact, yet contributed significantly to the mid-period negative return and subsequent positive return claw-back.
Profitability and Growth cumulative returns also began the period somewhat flat, yet became more negative as
time went on. Before we look at Industries, let’s take a peek at what some of these Style factors did day-by-day.

Figure 5

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 Figures 5-10 show the day-by-day portfolio level active exposures by Style factor (gray bars) as well as the
day-by-day Style factor contributions to return (blue bars). These combine to show the day-by-day cumulative
contribution to excess return from each Style factor (black line).

Figure 6

Figure 7

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 Figure 8

Figure 9

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 Figure 10

Beginning with Leverage, the figure clearly shows consistent underexposure to this factor over the year.
This, coupled with fairly consistently negative factor returns, provided a constant and beneficial excess return
contribution. Volatility was a bit more nuanced, with the active exposure moving around a fair bit, yet staying
constantly overexposed compared to the benchmark. The early period factor returns were quite negative, which
led to large early losses, yet flattened out after the midpoint. Profitability was somewhat reversed in that the
portfolio was constantly under-exposed to more profitable securities, with under-exposure increasing as time
went on. Early on, this did not have a big impact on the portfolio, but the contribution to return became much
more negative after the mid-point of the analysis.

Growth showed a relatively constant overexposure to higher growth securities. The return contribution looked
initially similar to Profitability by starting off muted, but then became more negative, before flattening out in the
later months.

Market Sensitivity, Figure 9, made an interesting return contribution. The portfolio was constantly in higher beta
securities and these initially didn’t contribute much to excess return. Starting around the end of 2015, higher-
beta securities did quite poorly, which led to a large negative return. This reversed around first-quarter 2016
and high-beta securities performed well, with some large swings at the end.

Based on the above Figures, the portfolio appeared to have fairly consistent active exposures to the Style
factors, likely due to limited trading, where the day-to-day movement of the Style factors themselves generally
incurred significant losses on the portfolio. In this case, the manager might have considered doing more to limit
unintended Style factor bets, while focusing on intended bets, in order to better track the benchmark.

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 Figure 11

Figure 12

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 Figure 13
Average Bench-
Average Bench- Average "Portfolio mark Active
Total Portfolio mark Active Contribu- Contribu- Contribu-
Asset Company Industry Return Weight Weight Weight tion” tion tion
ALEXION
ALXN Biotechnology -35.41% 4.34% 0.34% 4.00% -1.56% -0.14% -1.53%
PHARMACEUTICALS INC
BIIB BIOGEN IDEC INC Biotechnology -40.13% 3.46% 0.63% 2.83% -1.58% -0.36% -1.30%
VERTEX
VRTX Biotechnology -30.34% 3.87% 0.25% 3.62% -1.26% -0.09% -1.28%
PHARMACEUTICALS INC
INTERCEPT
ICPT Biotechnology -40.89% 2.44% 0.03% 2.42% -0.91% -0.02% -0.97%
PHARMACEUTICALS IN

Figure 14
Average Bench-
Average Bench- Average "Portfolio mark Active
Total Portfolio mark Active Contribu- Contribu- Contribu-
Asset Company Industry Return Weight Weight Weight tion” tion tion
Electronic
Equipment,
FIT FITBIT INC -67.58% 0.95% 0.00% 0.95% -1.89% -0.01% -1.94%
Instruments &
Components
Life Scienc-
ILMN ILLUMINA INC es Tools & -35.71% 3.78% 0.24% 3.55% -1.66% -0.11% -1.65%
Services
ALEXION
ALXN Biotechnology -35.41% 4.34% 0.34% 4.00% -1.56% -0.14% -1.53%
PHARMACEUTICALS INC
BIIB BIOGEN IDEC INC Biotechnology -40.13% 3.46% 0.63% 2.83% -1.58% -0.36% -1.30%
VERTEX
VRTX Biotechnology -30.34% 3.87% 0.25% 3.62% -1.26% -0.09% -1.28%
PHARMACEUTICALS INC
Internet
BIDU BAIDU INC ADR Software & -30.98% 0.84% 0.00% 0.84% -1.19% 0.00% -1.23%
Services
INTERCEPT
ICPT Biotechnology -40.89% 2.44% 0.03% 2.42% -0.91% -0.02% -0.97%
PHARMACEUTICALS INC

Next, we will look at the securities’ industries to see how they contributed to active return. Figure 11 shows
limited contribution to return from most Industries, with Biotechnology as the exception. This is collaborated in
Figure 12, which showed Biotechnology was by far the largest detractor from return, at -2.00%. The average
active exposure shows a large overweight to Biotech at an average of 11.15%. Presumably the manager
intended to greatly overweight Biotech with unfortunate results. This can be seen in more detail when looking at
the asset-level analysis in Figure 13. Here we see that the top four overweight Biotech securities combined to
produce a -5.08% active return, with Figure 14 showed these are four of the top seven negative contributors to
active return.

Thus far, we have taken a detailed look into how the portfolio performed from an Active Return standpoint. It will
be further insightful to see how much risk the portfolio took on to achieve its Active Return.

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 Figure 15

Active Risk
Figure 15 provides the decomposition of the predicted annual Active Risk of the portfolio as of June 30,
2015, the first date of analysis. A few things stand out. The Predicted Active Risk of 4.93% is roughly half
the observed Active Risk of 10.11% we saw earlier. Further, we see that Style’s contribution to Predicted
Active Risk is actually smaller than the Industry’s contribution to Predicted Active Risk. This emphasizes the
importance of monitoring risk on a regular basis and highlights the fact that market movements can have a
large impact on predictions, which makes a yearly prediction especially susceptible to changes.

Figure 16

Figure 16, Factor Group Contribution to Active Risk, shows the contribution to Predicted Active Risk from Style
and Industry over the year. Noticeably, Style started out as a small contributor, as we saw in Figure 15, yet
as the year progressed Style jumped significantly, while Industry began to taper off. Figure 17 provides the
day-by-day Active Predicted Risk for the year. As expected, the Active Predicted Risk of the portfolio increased
significantly as the year progressed and as movements in the market influenced forward predictions. Again,
this demonstrates the need to constantly monitor a portfolio’s risk, as market movements and transactions can
have a significant impact on the portfolio’s positioning.

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 Figure 17

Adding to this point, Figures 18-20 provide a graphical view of the daily active exposure and daily percent of
Predicted Active Risk for some of the more volatile Style factors. Similar to the exposure Figures we reviewed
for attribution, these figures provide an informative look at how the exposures changed over the month and
how that impacted the percent of Active Risk. Special attention should be paid to the magnitude of the axis. For
example, Volatility reached a maximum 7% of Active Risk, where Market Sensitivity was about 20%. Looking
at Figure 18, we can see the level of risk from Short-Term Momentum dramatically increased early in 2016,
while the active exposure became quite negative, which indicates that the securities’ short-term returns of the
portfolio fell quite a bit compared with the benchmark. Market Sensitivity also showed a dramatic and sudden
jump in percent of Active Risk around the end of the first quarter in 2016, even with a fairly gradual increase
in exposure. Again, the Figures confirm that risk and exposure can change quickly and in unexpected ways,
which again shows how important it is to frequently monitor the portfolio’s risk profile. Thus far, we have looked
at Active Risk from a Factor level. Now let’s take a look deeper at the security level.

Figure 18

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 Figure 19

Figure 20

Figure 21

Figure 21 shows the top five securities ranked by percent of Active Risk as of June 30, 2015, the first date of
the analysis. Additionally, the figure shows the Active Weight (the weight of the security in the portfolio minus
that same security’s weight in the benchmark) and MCAR. The MCAR provides helpful information – as noted
earlier, the total Active Risk is the sum of all of the individual securities’ active weights multiplied by their MCAR.

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 Thus, a large MCAR and-or higher active weight will lead to a higher contribution to Active Risk and thus a
higher percent of Active Risk for any given security.

In Figure 12, we observed that three of the worst performing securities for the year in Figure 14 show up
as having the top five highest levels of predicted percent of Active Risk at the start date of analysis. This
clearly shows our model’s ability to indicate how a potential concentration of risk could lead to unexpected or
undesirable returns. A manager should look at these riskier securities in conjunction with a factor-level risk
analysis and consider if these active bets are appropriate or if they should be reduced to avoid excess risk
exposure. To put it another way, factor- and security-level risk analysis will provide a means to identify sources
and concentrations of risk. The manager should then use that information to determine if the weightings of
securities and by extension the portfolio’s exposure to risk factors is too high and should be reduced.

The manager should extend this same analysis to the Style factors as well. Figure 22 shows the Style factor
active exposures and the percent of Active Risk at the beginning of the analysis. Unsurprisingly, Volatility
contributes the largest percent of Active Risk among Style factors, despite having a fairly moderate active
exposure. By looking at Figure 23, we can further drill to determine where the sources of Volatility came from.

Figure 22

Figure 23

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 Figure 23 shows the top security-level contributors to Factor Risk for the Volatility factor. Once again, we see
three of the same Biotechnology securities listed earlier.

Additional concepts
So far, we have decomposed the portfolio’s Active Return and Active Risk and uncovered some important
information. We have seen that managing risk from the top level down to the security level is an essential part
of portfolio construction and management. And we witnessed the connection between sources of predicted
risk and subsequent sources of return. There are a few additional tools, such as statistical models and stress
testing, that a manager can use when monitoring his or her portfolio’s risk.

In addition to analyzing a portfolio using a factor risk model, there is benefit to using multiple models, including
statistical models. Statistical models are different from factor models because in a statistical model the factors
are not chosen in advance and are indeed unknown. Stat models, by nature of not being fixed to pre-specified
factors, have the flexibility to observe sources of risk that the factor models may not pick up. The model
process itself will isolate independent “factors” that have explanatory power. While the limitations of these
models are clear (they cannot be used to determine overweight or underweight to observable factors and thus
cannot explain what factors are adding or subtracting risk), they are very useful at the topline and for security-
level analysis.

Figure 24

In Figure 24, we can see the portfolio’s predicted annualized Active Risk over time, using a factor model in blue
and a statistical model in red. One can see that over different periods the different models had varying views of
Predicted Active Risk. Initially, the statistical models showed the portfolio having a higher Predicted Active Risk
than the factor models, sometimes by quite a bit. For a brief period in the second half of the analysis period,
the factor model shows higher Predicted Active Risk. And at the end of the analysis period, the statistical model
show quite a bit higher Predicted Active Risk. This leads to the obvious question of what model is “right”. The

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 simple answer is that they each provide insight into the portfolio’s risk profile. At times when the statistical
model’s Predicted Active Risk is higher, it makes sense to look at the security level percent of Predicted Active
Risk to see if certain securities have a higher risk profile than the factor models show. This could mean that
there is something going on in the market that the factors models are not picking up, but the statistical model is.
In general, it benefits the portfolio analysis process to look at all available models to get a better picture of the
sources of risk.

By comparing Figure 25, which used the statistical model, with Figure 21, which used the factor model, we
see that each model produced a somewhat different prediction of percent of Active Risk for each security. And
in fact, each also produced a slightly different list of the top highest-ranked risk contributors. Splunk Inc., for
instance, had a much higher predicted percent of Active Risk in the statistical model than it did in the factor
model. This is a potential source of hidden risk that the factor model may not have picked up, and this is
something the manager might want to consider when making weighting decisions. For further details, please
see Axioma’s paper “More than Just a Second Risk Number: Understanding and Using Statistical Models.”

Figure 25

Stress Testing
In addition to decomposing risk, managers often have an interest in seeing how their portfolios would perform
in certain situations. This is commonly referred to as scenario analysis or stress testing. Below we can see two
different stress-test methods. The first, as seen in Figure 26, takes the current portfolio factor exposures, as of
June 30, 2015, and applies the factor returns as they existed during certain market conditions. For instance,
had the portfolio been similarly constructed during the Black Monday Stock Market Crash in 1987, it would
have dropped by around -20%, while the Russell 1000 Growth index would have fallen by around -18%, thus
underperforming by around 2%. Conversely, had the portfolio been similarly constructed during the Subprime
Crisis in 2007, the portfolio would had dropped by around -8% versus the benchmark decline of -9%, and thus
would have outperformed by around 1%.

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 Figure 26

Figure 27 shows a somewhat different method of computing a stress test. In this case, we are shocking specific
factors today using the current risk model. We can see that shocking inflation by 5% leads to a positive portfolio
return of around 1%, versus a roughly flat benchmark return under that same shock. These two types of stress
tests are helpful by using actual occurrences, as well as potential changes to factors, to see how the portfolio
would perform.

Figure 27

Optimization
One final concept worth discussing is optimization. While the background on optimization is outside the scope
of this paper (see appendix for further details on optimization), it does have some relevance as optimization,
in this case, is trying to solve for minimizing Predicted Active Risk versus the Russell 1000 Growth, while

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 maintaining the same securities as the initial portfolio. The idea is to maintain the portfolio’s securities (with the
assumption that the manager is trying to capitalize on a high conviction list), while letting the optimizer decide
on the Style and Industry factor exposures that best minimize Active Risk.

In Figure 28, we can see the results of this optimization rebalance run quarterly over the same period of
analysis. By comparing Figure 28 with Figure 2, we see the optimized portfolio returned 2.67%, again by
keeping the securities held the same, compared with the original portfolio that returned -8.00%. In other words,
the one-year return improved by more than 10% by focusing on minimizing the risk from Style and Industry
factors while maintaining the original list of securities.

Figure 28

Conclusions
Analysts, managers, and risk officers that can understand risk and how to decompose it have a powerful tool
to better understand their investments. Risk models and risk analysis can prevent a portfolio from taking on
undesired and/or unintended bets and can prevent intended bets from imposing a greater-than-desired amount
of risk on a portfolio. Axioma’s solutions isolate, describe and mitigate the risks in a portfolio from the top,
factor, and individual security levels. This level of insight is immensely valuable to financial professionals in their
efforts to limit and control their investment risks.

Best Practices in Factor-Based Analytics page 20

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Contact us to learn more about how Axioma can bring more
information and insights to your investment process.

United States and Canada: +1-212-991-4500 Sales: [email protected]

Europe: +44-207-856-2424 Client Support: [email protected]
Asia: +852-8203-2790 Careers: [email protected]

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