CFAI Book(V6P142) says that the factor-model-based benchmark may not be investable. Why?
- Could include very illiquid stocks or closely held stocks ( low float)
How can u invest in a factor model? Its a model? Maybe I am missing something
factor-model-based . Not the model itself , which you have to buy from a vendor, the picks generated by the model
doesnt a factor based model include things like fundamentals and economic variables? You can take a position in an equity that tracks somewhat closely to a countrys gdp, but it won’t be exact, similarly any fundamentals. So your model might give you a benchmark that is equal to 0.7*uk gdp growth + 0.5*ftse 100 retn + 0.1* uk employment growth, this might give you a benchmark return of 5% in a month, but you wouldn’t be able to replicate this benchmark very easily, and any rep would have a massive tracking error as you cant invest directly at employment or gdp returns
The model-based may include positions that are unsuitable, irresposible, or impossible for a mgr to take. For example: As was said above the model may say to take a 50% position in a closely held stock, but if only 20% is available to the mkt there’s no way a mgr could take this position (excluding leveraging it, but even that may be difficult for a security that’s closely held) Or the factor model may have a large short position included which would be irresponsible for a mgr to hold and possibly unsuitable under portfolio investment guidlines.
Its because you can create different benchmarks with the same factor exposures. If I told you I created a model that uses a beta factor exposure of 1.5, I bet the combinations would be endless of what i could create, hence uninvestable.
From CFAI, We can build multiple benchmarks with the same factor exposures, but each benchmark can earn different returns. For example, we can construct two different portfolios, each with a beta of 1.2 (“normal beta”), but the portfolios can have materially different returns.
May I know what does it mean, if with the same factor exposures, wouldn’t the returns be the same?
As someone stated above, imagine if 1 person creates a synthetic position and 1 does it the good ol’ fashion way buy and sell securities. What happens if your synthetic positions get all jacked up. will they still have the same return?