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Equity Valuation and Portfolio Management by Harry M. Markowitz, Frank J. Fabozzi

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IMPLEMENTATION

Building portfolios based on views about a small number of individual securities is relatively straightforward. After ranking the universe of securities and deciding upon which ones to own, the portfolio manager simply buys shares of those securities. Part of the challenge associated with dynamic factor approaches to portfolio management rests in the implementation. Because the returns associated with individual securities contain an element of idiosyncratic risk, imperfect exposure to various factors is generally unavoidable. As such, the implementation of portfolio management strategies based on dynamic factor allocations is fraught with error. However, the problem of implementation error has been alleviated in recent years by several developments facilitating the implementation of factor-based strategies.

Physical Securities

The implementation of dynamic factor strategies with individual stocks requires a portfolio with a large number of holdings in order to achieve suitable factor exposure and avoid an excessive degree of security-specific risk. A portfolio of securities can be constructed in order to provide exposure to a specific set of factors. With a large enough number of holdings, the idiosyncratic return is minimized and the overall portfolio will reflect its factor content rather than the constituent securities. The securities are included in the portfolio in order to capture the returns associated with the characteristics they exhibit. Much like an insurance ...

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