The Number of Estimates Needed for Mean/Variance

Analyses
The problem with securities is that there are too many of them. This is also true for pools of
securities such as mutual funds. Worldwide, there are hundreds of thousands of securities and
tens of thousands of mutual funds.

In the United States alone there are roughly ten thousand mutual funds. To perform a
mean/variance analysis of portfolios that could contain any of them would require estimates for
the future values of:

• 10,000 expected returns,

• 10,000 standard deviations, and
• 100,000,000 (10,000*10,000) correlation coefficients

To be sure, this overstates the magnitude of the problem. We know that 10,000 of the correlation
coefficients will equal 1.0, since each fund will be perfectly correlated with itself. Moreover, for
each entry below the main diagonal of the correlation matrix there is a corresponding entry
above it (that is, cc(i,j)=cc(j,i)). Thus the number of potentially different correlation coefficients
to be estimated will be only (!) (10,000*10,000 - 10,000)/2, or 49,995,000.

More generally, with N different assets, we require:

• N expected returns
• N standard deviations
• (N^2 - N)/2 correlation coefficients

for a grand total of (N^2 + 3*N)/2 different estimates.

There are two consequences of the fact that problems involving large numbers of assets require a
great many estimates. The first concerns the sheer computational requirements for optimization
or even the determination of the risk and return of a given portfolio. Fortunately, ever-declining
computer costs can ameliorate the pain caused on this front. But a second problem remains -- it
is simply too difficult to estimate each of the required values explicitly.

The Use of Historic Data

At first glance it might seem that the estimation problem could also be solved simply by
unleashing a sufficient amount of computer power. Why not obtain a set of historic returns for
the N assets and compute historic mean returns, standard deviations of return and correlations
among the returns? Even for large values of N this could be done in reasonable time and for
reasonable cost, although storage of each of the resulting estimates would use up a considerable
amount of computer space.
Issues of cost and time aside, such an approach would not provide a good solution. A set of
historic data provides only a sample of possible outcomes. The statistics we desire are those that
describe the entire underlying "return-generating" process. But the statistics from a sample are
likely to differ in potentially significant ways from those that are appropriate for tasks such as
risk estimation and portfolio optimization. In statistician's terms, the numbers obtained from
historic data are "subject to error". More simply put, they include noise. In some cases this may
be reasonably benign. For example, if some values are overstated and others understated, a
simple average of historic values may provide a quite accurate estimate of the expected value of
the true process. This suggests that the use of historic data for estimating the expected returns
and risks of pre-specified portfolios might be an acceptable practice. However, the use of
optimization to find the best portfolio for a given investor will be fraught with hazard if historic
data are used, since optimization programs look for unusual values, and such values are far more
likely to include error than those that are not unusual. The same danger lurks when evaluating
portfolios chosen in simpler ways, but with knowledge of the behavior of the assets over the
historic period. In either case, the purported risks and returns for the portfolios will be biased
toward favorable estimates (higher expected returns and/or lower risks), and the portfolios will
almost certainly be inefficient in prospective terms. More precisely, portfolios that appear on the
efficient frontier using unadjusted historic data will almost certainly plot below the true efficient
frontier that could be constructed if the correct future risks, expected returns and correlations
were known.. Unhappily, of course, we can never know the location of the true efficient frontier,
since we can never know precisely the correct future risks, expected returns and correlations.

The problem with using historic data when estimates are required for a large number of assets
can be seen by comparing the required number of estimates with the data available for the
estimation. Assume that returns are available for N assets for T periods (e.g. months). In all,
N*T numbers are available in the empirical database. But we need to estimate (N^2 + 3*N)/2
different numbers (expected returns, standard deviations and correlation coefficients). Taking
the ratio of the former to the latter gives the ratio of numbers available per number to be
estimated. It is 2*T/(N+3). The table below shows the ratio of the numbers available to the
numbers being estimated for selected values of N and T.

N T available/estimated
10 60 9.23
100 60 1.17
1,000 60 0.12
10 120 18.46
100 120 2.33
1,000 120 0.24
10 840 129.23
100 840 16.31
1,000 840 1.68
10,000 840 0.17
For the common cases in which monthly returns are used for estimation, each set of three rows
corresponds to 5, 10 and 70 years (the latter being approximately the number of years in longer-
term databases.

Cases in which fewer numbers are available than are to be estimated are clearly beyond the pale.
Yet such combinations can easily arise in practice. This is often encountered in scenario
analyses, when judgmental forecasts of asset returns in a limited set of possible future situations
are used as the foundation for portfolio construction. But it is not uncommon in empirical
analyses of historic data.

One might assume that the problem of insufficient data can be mitigated sufficiently by simply
using more data. Unfortunately this usually requires going farther back in history, and the longer
the historic period covered, the less likely is the maintained hypothesis that the underlying joint
probability distribution generating the returns has been the same.

While these dilemmas cannot totally be resolved, there are ways to mitigate the problem.
Needed are procedures that can produce estimates of risks, returns and correlations closer to the
desired future values than those obtained by simply using historic statistics. Two ingredients are
required.

• First, historic data must be "smoothed" to try to focus on underlying relationships that are
more likely to be true in the future and to ignore deviations from those relationships that
are more likely to be due to random noise or errors. The tools used most often to
accomplish this are factor models -- the subject of this chapter.
• Second, good financial economic theory must be utilized to adjust estimates of risks,
expected returns and correlations until they bear some reasonable relationship with one
another. This involves the use of concepts and models associated with equilibrium in
efficient markets -- a subject that is treated at length in a later chapter.
Linear Factor Models

Contents:
• A Generic Linear Factor Model
• Terminology
• Decomposing Returns
• Matrix Representation of Factor Models

A Generic Linear Factor Model

The Equation

A linear factor model relates the return on an asset (be it a stock, bond, mutual fund or something
else) to the values of a limited number of factors, with the relationship described by a linear
equation. In its most generic form, such a model can be written as:

ri = bi1*f1 + bi2*f2 + .... + bim*fm + ei

where:

ri = the return on asset i

bi1 = the change in the return on asset i per unit change in factor 1
f1 = the value of factor 1
bi2 = the change in the return on asset i per unit change in factor 2
f2 = the value of factor 2
... = terms of the form bij*fj with j going from 3 to m-1
fm = the value of factor m
bim = the change in the return on asset i per unit change in factor m
m = the number of factors
ei = the portion of the return on asset i not related to the m factors

For emphasis, the equation is sometimes written so that variables that are assumed to be known
before the fact are differentiated from those the value of which is generally not known until after
the fact. For example:

ri~ = bi1*f1~ + bi2*f2~ + .... + bim*fm~ + ei~

In this version, a tilde after a variable indicates that its value is not generally known in advance.
The values of such stochastic variables are uncertain. Thus we do not know what the return on
the asset (ri~ ) will be, since we do not know the values that the factors (f1~, f2~, .... ,fm~ ) will
take on, nor do we know the amount of the asset's return that will come from other sources (ei~).
On the other hand, we do know (or at least assume that we know) the sensitivities of the return
on the asset to each of the factors ( bi1, bi2, ....,bim) -- these are deterministic (not subject to
uncertainty). Somewhat differently put, they are parameters in the model.

Purists will note that it is unusual to place tildes after stochastic variables rather than over them.
The latter is indeed the convention in media that are not typographically challenged. Our
approach is simply a pragmatic response to the limitations of standard browser formats.

The Key Assumption

The factor model equation may appear to make a significant statement about the relationship
between an asset's return and the values of the enumerated factors, but this is not so. For
example, one could choose any arbitrary set of bij 's and fj's, then simply define the residual as:

ei~ = ri~ - [bi1*f1~ + bi2*f2~ + .... + bim*fm~]

The factor equation would then hold precisely, but could have no economic content at all. To
make the equation have meaning, two assumptions are made. One is relatively innocuous. The
other is not.

First, the residual return (ei~) is assumed to be uncorrelated with each of the factors:

corr (ei~, fj~) = 0 : for every j from 1 to m

This is not as restrictive as it may seem. Consider, for example, a case in which the residual
return is correlated with factor 1. By adjusting the factor exposure (bi1) appropriately, the
correlation of the residual with the factor can be made to equal zero. Moreover, this can be done
for every factor. In fact, in simple settings using historic data, multiple regression procedures
can be used to find a set of factor exposures (bij 's) that will give residual returns that are
uncorrelated with each of the factors. Why? Because standard linear multiple regression
methods select slope coefficients (here, the bij 's) that minimize the variance of the residual (here
ei). But this will insure that the residual is uncorrelated with each of the independent variables
(here, the fj's), since the removal of any such correlation by changing one or more bij's will
reduce the variance of the residual.

Thus the assumption that the residual is uncorrelated with each of the factors is convenient, but
does not give the linear factor model much power. However, the second assumption does.

The key assumption of a linear factor model is that the residual for one asset's return is
uncorrelated with that of any other:

corr (ei~,e j~) = 0 : for every i not equal to j, with i and j running from 1 to m

This means that the only sources of correlations among asset total returns are those that arise
from their exposures to the factors and the covariances among the factors. The residual
component of an asset's return is assumed to be unrelated to that of any other asset, and hence
totally specific to that asset. In other words, the risk associated with the residual return is
idiosyncratic to the asset in question.
This assumption makes a linear factor model powerful in the sense that it rules out many possible
combinations of outcomes. But greater power comes at a cost. The more restrictive a model, the
greater the chance that it may be inconsistent with reality. For this reason it is incumbent on the
Analyst to try to capture the most important sources of correlations among asset returns by
including a sufficient number of factors and attempting to focus on the most important ones. This
being said, as in the construction of any model, parsimony is a virtue, since the goal is to include
"signals" and avoid "noise".

Non-linear Relationships

We have termed the standard factor model linear which, strictly speaking, it is. However this is
far less restrictive than might first seem. There are no restrictions on correlations among the
enumerated factors, so it perfectly possible to include some that are correlated with others or are
transforms of others. For example, assume that the desired relationship is a quadratic one in
which ri is related to two factors, fa and fb as follows:

ri = bi1*fa + bi2*fb + bi3*fa2 + bi4*(fa*fb) + ei

To put this in our standard format, define:

f1 = fa
f2 = fb
f3 = fa2
f4 = fa*fb

Then the relationship can be written as a linear function of these new variables:

ri = bi1*f1 + bi2*f2 + bi3*f3 + bi4*f4 + ei

In cases of this sort it may be difficult to estimate the values of the sensitivities (bij's) from
historic data because the new factors are highly correlated with each other, but there is no reason
why such a format cannot be employed if good estimates can be obtained.

To avoid needless carping on the need to define factors to allow a linear format for the overall
relationship, we henceforth will use the shorter term: factor models.

Expected Residual Returns

Thus far we have imposed no restrictions on the expected returns of the factors or on the asset's
residual returns (ei's). In general, we will not do so. This allows the expected return of ei to be
positive, negative, or zero for any asset. However, in some applications it is useful to divide the
expected non-factor return into two components -- a known expected value and an unknown
residual component with an expected value of zero. As typically written, the equation becomes:

ri~ = bi1*f1~ + bi2*f2~ + .... + bim*fm~ + (ai + ei~)

where the expected value of ei~= 0.

As the choice of letter suggests, the equation is often written with the ai term first:

ri~ = ai + bi1*f1~ + bi2*f2~ + .... + bim*fm~ + ei~

In some cases the first term is called the asset's alpha value, but at this point we use the more
humble notation of "a".

Terminology
Factor models are used in many domains in the field of investments, so it should not be
surprising that different factors are used and different terms employed to describe the key
components.

Factors (the fj's) may be::

• macro-economic variables
• returns on pre-specified portfolios,
• returns on zero-investment strategies (long and short positions of equal value) giving
maximum exposure to a fundamental or macro-economic factors,
• returns on benchmark portfolios representing asset classes,
• or something else.

The bij coefficients may be called:

• factor exposures,
• factor sensitivities,
• factor loadings,
• factor betas,
• asset exposures
• style
• or something else.

The ei term may be called:

• idiosyncratic return,
• security-specific return,
• non-factor return,
• residual return,
• selection return
• or something else.

Different problems require different factors and emphasize different economic relationships.
The job of the Analyst is to either construct and apply an appropriate factor model for the task at
hand or to at least understand the underlying structures and economic meanings of models
constructed by others.

Decomposing Returns
A factor model is especially useful when analyzing historic asset returns, since such a model
allows the Analyst to separate components of the overall return of the asset. For such purposes
it is useful to write the underlying model as:

rit = bi1*f1t + bi2*f2t + .... + bim*fmt + eit

where:

rit = the return on asset i in period t

bi1 = the change in the return on asset i per unit change in factor 1
f1t = the value of factor 1 in period t
bi2 = the change in the return on asset i per unit change in factor 2
f2t = the value of factor 2 in period t
... = terms of the form bij*fj with j going from 3 to m-1
fm = the value of factor m
bim = the change in the return on asset i per unit change in factor m
m = the number of factors
eit = the residual return on asset i in period t

While the subscript t and the term period suggest the traditional application in which each period
represents a different historic realization (for example, a different month in the past), the
concepts can be used as well in an ex ante analyses, in which each period (t) represents a
different possible scenario or realization that could occur in the next (future) period. To
emphasize the context, we will sometimes use the subscript s (for scenario) instead of t (for time
period). In the former case, there are S scenarios. In the latter, there are T time periods.

Note that in this representation the bij terms are not given a t (period) or s (scenario) subscript.
This is innocuous in the latter case, since every scenario involves the same future period.
However, in the former case, the assumption is quite restrictive, since it indicates that the asset's
exposures to the factors were the same in every period. In some cases involving ex post returns,
different exposures will be estimated for different time periods, with bij values replaced with bijt
values.

Matrix Representations of Factor Models

To simplify notation and to facilitate computation it is useful to switch from a subscripted
notation to a matrix representation. As usual, we utilize Matlab conventions. We consider
several cases in turn, focusing on decomposition of returns, be they over time or over scenarios.
For simplicity we cast our examples in terms of historic returns over different time periods, but
the interpretations can easily be adapted to cases involving different possible scenarios over a
single future time period.

One asset, one realization

First consider the case in which there is one asset and one time period (looking backward) or
scenario (looking forward).Let b be a {1*m) vector of the asset's factor exposures, let f be an
{m*1} vector of actual factor values, r a scalar representing the asset's return and e a scalar
representing its residual return. The factor model equation can then be written as:

r = b*f + e

For example, let the asset's exposures to the factors be:

b = [ 0.1 0.3 0.6 ]

Assume that the realized values of the factors in a given year were:

f = [ 4
7
20 ]

If the total return on the asset (r) was 16.0 percent, then:

e = r - b*f
= 16.0 - 14.5
= 1.5

Thus, in the year in question, the asset's residual (non-factor related) return was 1.5%, while its
factor-related return was 14.5%.

One Asset, Multiple Realizations

Next, consider a case in which there are many historic periods (looking backward) or scenarios
(looking forward). Let there be T such alternatives. For each one, there will be a return on the
asset, so that the scalar r will be replaced by T values, which can be written as a {1*T} (row)
vector. Similarly, for every alternative there will be a set of factor values, so that f will be
replaced by a {m*T} matrix. This will give a residual return for each of the periods or cases, so
that the scalar e will be replaced by a {1*T} vector. We assume that the asset's factor exposures
will be the same in each case, so that b will remain a {1*m} vector.

The relationships among these variables can then be written with the following succinct
equation:

r = b*F + e
Given r, b and F, the residual returns can be found by performing the operation:

e = r - b*F

For example, assume that in the last two years the realized returns for the asset were:

r = [ 16 4 ]

while the factor values were:

F = [ 4 3
7 2
20 10 ]

This implies that the factor-related returns were:

b*F = [ 14.5 6.9 ]

and the residual returns were:

e = r - b*F = [ 1.5 -2.9 ]

In each case the first column corresponds to the previous one-period example, which is a special
case (with T=1) of this present version.

Multiple Assets, Multiple Realizations

An even more general case can subsume both of the prior ones as special cases. Assume that
there are N assets and T realizations. Let:

R = an {N*T} matrix, where R(i,t) is the return on asset i in realization t

B = an {N*m} matrix, where B(i,j) is the exposure of asset i to factor j

F = an {m*T} matrix, where F(j,t) is the value of factor j in realization t

e = an {N*T} matrix, where e(i,t) is the residual return on asset i in realization t

The factor model then becomes:

R = B*F + E

and the matrix of residual returns can be found by computing:

E = R - B*F

As an example, assume that we have four assets, with exposures to three factors given by:
B =[ 0.1 0.3 0.6
0.2 0.8 0
0 0.7 0.3
0 0 1.0 ]

If the asset's returns in the two years were:

R =[ 16 4
7 1
8 6
22 7 ]

Then the residual returns were:

E = [ 1.5 -2.9
0.6 -1.2
-2.9 1.6
2.0 -3.0 ]

Not surprisingly, the first security is the one used in the prior case.

Note that three different dimensions are involved here (two periods, three factors, and four
assets). The matrices, with row and column labels are as follows:

Returns (R):
period 1 period2
security 1 16.0 4.0
security 2 7.0 1.0
security 3 8.0 6.0
security 4 22.0 7.0
Asset Exposures (B):
factor 1 factor 2 factor 3
security 1 0.1 0.3 0.6
security 2 0.2 0.8 0.0
security 3 0.0 0.7 0.3
security 4 0.0 0.0 1.0
Factor realizations (F):
period 1 period2
factor 1 4.0 3.0
factor 2 7.0 2.0
factor 3 20.0 10.0
Factor-related Returns (B*F):
period 1 period2
security 1 14.5 6.9
security 2 6.4 2.2
security 3 10.9 4.4
security 4 20.0 10.0
Residual returns (E = R - B*F):
period 1 period2
security 1 1.5 -2.9
security 2 0.6 -1.2
security 3 -2.9 1.6
security 4 2.0 -3.0
Factor-based Expected Returns, Risks and Correlations

Contents:
• Factor-based Asset Expected Returns
• Factor-based Asset Covariances and Variances
• Factor-based Portfolio Expected Returns and Risks

Factor-based Asset Expected Returns

What is the expected return for a single asset whose return is generated by a factor model? The
answer conforms nicely with intuition -- each uncertain term in the factor model equation can
simply be replaced with its expected value. Thus, if:

ri~ = bi1*f1~ + bi2*f2~ + .... + bim*fm~ + ei~

It will be the case that:

ev(ri) = bi1*ev(f1) + bi2*ev(f2) + .... + bim*ev(fm) + ev(ei)

where ev(x) denotes the expected value of x

To see why this is the case, recall that for a given possible future scenario s:

ris = bi1*f1s + bi2*f2s + .... + bim*fms + eis

Now, multiply each term by prs , the probability that the scenario will occur:

prs*ris = prs*bi1*f1s + prs*bi2*f2s + .... + prs*bim*fms + prs*eis

This equation will continue to hold (the left side value must equal the right side value) and there
will be one such equation for each possible scenario.

Next, add together the equations for all S possible scenarios. Letting sums( ) denote the sum for
s=1...S, we have:

sums(prs*ris) = sums(prs*bi1*f1s) + sums(prs*bi2*f2s) + .... + sums(prs*bim*fms) + sums(prs*eis)

Collecting terms that have scenario subscripts gives:

sums(prs*ris) = bi1*sums(prs*f1s) + bi2*sums(prs*f2s) + .... + bim*sums(prs*fms) + sums(prs*eis)

By definition, the first sum is the asset's expected return, the next m sums are the expected
returns of the factors, and the last term is the expected residual return. Thus:

ev(ri) = bi1*ev(f1) + bi2*ev(f2) + .... + bim*ev(fm) + ev(ei)

as asserted.

If the expected residual return is represented by ai, the equation can be written as:

ev(ri) = ai + bi1*ev(f1) + bi2*ev(f2) + .... + bim*ev(fm)

or, in matrix terms:

e(i) = b*ef + a(i)

where:

e(i)= r*pr'
ef = F*pr'
a(i) = e*pr'

Here, pr represents a {1*S} vector of probabilities, r a {1*S} vector of asset returns, F a {M*S}
matrix of factor values, and e a {1*S} vector of residual returns. As previously, b represents a
{1*M} vector indicating the asset's sensitivities to the factors. The computed values are: e(i), a
scalar representing the asset's expected return; ef, an {M*1} vector of factor expected values;
and a(i), a scalar representing the asset's expected residual return.

This rather tortuous proof suffices for other situations involving linear functions. The expected
value of a variable that is a linear function of other variables will itself be a linear function of the
expected values of the variables in question, using the same constants (here, bij values).

The equation for an asset's expected return could be used to compute the expected return on each
asset, one at a time. However, it is far more efficient to generalize it so that the entire vector of
asset expected returns can be computed in one operation. This is straightforward. Let:

e = an {N*1) vector of asset expected returns

B = an {N*m} matrix of factor exposures, where B(i,j) is the exposure of asset i to factor j

ef = an {m*1} vector of asset expected returns

a = an {N*1} vector of the expected residual returns

e = an {N*1) vector of asset expected returns

Then:

e = B*ef + a
This is a Matlab expression which requires one operation to do the entire job.

With respect to expected returns, it would appear that the use of a factor model has actually
increased the number of required estimates. In this approach, for N assets the Analyst needs N
estimates of a(i) plus estimates of the expected values of the M factors. While this is true, there
are at least some cases in which it is reasonable to assume that each asset has the same expected
residual return, or that each such expected residual return is related in a simple way to the asset's
factor sensitivities. In such cases, the number of estimates required to specify asset expected
returns may be considerably smaller than N. Even when this is not so, a small increase in the
size of the task of estimating expected values is a reasonable price to pay for the substantial
decreases in the magnitude the task of estimating risks, as the next section shows.

Factor-based Asset Covariances and Variances

To determine the relationship between factor characteristics and those of an asset it is useful to
re-examine the nature of covariance. Put in future terms, the covariance of asset i with asset j is
the expected value of the product of (1) the deviation of asset i's return from its mean and (2) the
deviation of asset j's return from its mean:

cov(ri,rj) = ev( (ri-ei)*(rj-ej))

From this is follows that if k is a constant:

cov(ri,k*rj) = ev( (ri-ei)*(k*rj-k*ej)) = ev( (ri-ei)*k*(rj-ej)) = k*ev( (ri-ei)*(rj-ej)) = k*cov(ri,rj)

In words: the covariance of a variable with a constant times another variable equals the constant
times the covariance of the two variables.

The definition of covariance also implies that if ri,rj, and rk are returns:

cov(ri,rj+rk) = ev( (ri-ei)*((rj+rk) - (ej+ek)) = ev( (ri-ei)*((rj-ej)+(rk-ek)) = ev( (ri-ei)*((rj-ej)+ ev( (ri-
ei)*((rk-ek)) = cov(ri,rj)+cov(ri,rk)

In words: the covariance of a variable with the sum of two variables equals the sum of its
covariances with the two variables. Clearly, a similar statement holds for the relationship
between the covariance of a variable with the difference between two other variables.

Now, consider the covariance between two assets (i and j), where the returns of each are
determined by a factor model. To keep notation to a minimum, let there be two factors. The
relationships are thus:

ri~ = bi1*f1~ + bi2*f2~ + ei~

rj~ = bj1*f1~ + bj2*f2~ + ej~

The goal is to determine the covariance between ri~ and rj~. Substituting the right-hand sides of
the equations, we have:

cov(ri~,rj~) = cov( (bi1*f1~ + bi2*f2~ + ei~ ), (bj1*f1~ + bj2*f2~ + ej~))

Using the relationships derived earlier, the right-hand side of this equation can be re-written as
the sum of nine covariances, since there are three terms in each component. However, some of
these will equal zero. The maintained assumptions of the factor model are that each residual is
uncorrelated with that of any other variable, and that each residual is uncorrelated with each of
the factors. However, since a variable's residual return will be correlated with itself, the
corresponding term should be included to cover the case in which i=j. Including only the terms
that could be non-zero, and dropping the tildes gives:

cov(ri,rj) = bi1*bj1*cov(f1,f1) + bi1*bj2*cov(f1,f2) + bi2*bj1*cov(f2,f1) + bi2*bj2*cov(f2,f2) + cov( ei,ej)

This can be written far more succinctly using matrix notation:

Cij = bi*CF*bj' + rvij

where:

Cij = the covariance between the returns on assets i and j

bi = a {1*m} vector of asset i's exposures to the m factors

CF = an {m*m} matrix of the factor covariances

bj = a {1*m} vector of asset j's exposures to the m factors

rvij = the covariance between the residuals on assets i and j

Note that rvij will equal zero if i and j are different, but will equal the variance of the asset's
residual if i=j.

A small amount of reflection on this derivation will indicate that the matrix version of the
formula is as applicable if there are more than two factors as it is if there are two.

The formula can be used to compute the variance of an asset's return since var(ri) = Cii.Thus:

var(ri) = bi*CF*bi' + rvii

More impressively, the formula can be generalized to compute the entire covariance matrix for
asset returns. As before, let:

B = an {N*m} matrix of factor exposures, where B(i,j) is the exposure of asset i to factor j

and

rv = an {N*1} matrix, where rv(i) is the residual variance for asset i (that is, the variance of ei)
Then in Matlab notation:

C = B*CF*B' + diag(rv)

where:

diag(rv) = a matrix with the elements of rv on the main diagonal and zeros elsewhere.

For problems involving many securities (N) and relatively few factors (m) the number of
potentially different estimated variables (those on the right-hand side of the equation) can be
very much smaller than the number of asset covariances (on the left-hand side of the equation).
For each of the covariances matrices (C and CF) we count only the elements on and below the
diagonal, since once those are known, the remainder can be filled in. Taking this into account,
the numbers of values to be determined for each component are:

C: (N2+N)/2

CF: (m2+m)/2

B: N*m

rv: N

The table below shows a few examples.

N m C CF B rv CF+B+rv
100 3 5,050 6 300 100 406
1,000 3 500,500 6 3,000 1,000 4,006
9,000 15 40,504,500 120 135,000 9,000 144,120
7,000 60 24,503,500 1,830 420,000 7,000 428,830

The first two rows are included for illustrative purposes. The third is representative of a typical
model used for U.S. mutual funds, with 15 broad asset class returns used for factors to explain
the returns of the many thousand mutual funds in the country. The fourth row is representative
of some commercial models that use a number of factors to explain the returns of the thousands
of common stocks in the United States.

As the table vividly illustrates, the number of potentially different asset covariances (in C) can be
huge. While the number of estimates required if a factor model is used (shown in the last
column) can be large, the use of such a model reduces a virtually intractable problem to one that
can be manageable.

Finally, we can compare the total number of estimates required with and without a factor model
for each of the four cases. In addition to the estimates required for covariances, those needed for
expected returns (e), factor expected returns (ef) and residual expected returns (a) need to be
taken into account. The table below shows the results:
 without with
N m C e CF B rv ef a
model model
100 3 5,050 100 6 300 100 3 100 5,150 509
1,000 3 500,500 1,000 6 3,000 1,000 3 1,000 501,500 5,009
9,000 15 40,504,500 9,000 120 135,000 9,000 15 9,000 40,513,500 153,135
7,000 60 24,503,500 7,000 1,830 420,000 7,000 60 7,000 24,510,500 435,890

The conclusion is the same. A factor model is a necessity for the estimation of risks and returns
if problems of any size are to be analyzed.

Factor-based Portfolio Expected Returns and Risks

All the work performed in the previous sections can be summarized with the two equations for
asset expected returns (e) and covariances (C):

e = B*ef + a

C = B*CF*B' + diag(rv)

It is now time to consider portfolios of assets.

The custom is to represent a portfolio by an {N*1} vector x in which each element is the
proportion (by value) invested in an asset and the sum of the x's equals 1. As usual, the
portfolio's expected return is given by:

ep = x'*e

and its variance by:

vp = x'*C*x

One could use the factor model-based equations to compute e and C, then the equations for
portfolio expected return and variance to compute the portfolio's characteristics. However, this
would require the creation of a possibly very large asset covariance matrix (C). An far more
attractive alternative combines the equations, simplifies, and then solves for ep and vp.

First, take the equations for expected return. Combine:

e = B*ef + a

and

ep = x'*e

to get:
e = x'*B*ef + x'*a

Grouping terms slightly gives:

ep = (x'*B)*ef + x'*a

The parenthesized expression involves multiplying a {1*N}vector by a {N*m} matrix. The

result is a {1*m} vector that we will call bp:

bp = x'*B

The terminology is not without a purpose, for each element of bp indicates the exposure of the
portfolio to a factor. In somewhat casual notation:

bpf = sumi (xi*bif)

More succinctly:

bp = a {1*m} vector of the portfolio's exposures to the m factors

where each exposure is a weighted average of the asset exposures to the factor in questions, with
proportionate portfolio holdings used as weights.

The expected return of a portfolio can thus be obtained by multiplying each of its bpj values by
the expected return of the associated factor and adding the weighted average of the asset residual
expected returns, using the portions invested in the assets as weights:

ep = bp*ef + x'*a

A similar approach can be used for computing a portfolio's variance, with very rewarding
reductions in computational requirements. Combine the equations for variance and covariance:

C = B*CF*B' + diag(rv)

and

vp = x'*C*x

to get:

vp = x'* B*CF*B'*x' + x'*diag(rv)*x

This rather menacing equation can be simplified by grouping:

vp = (x'* B)*CF*(B'*x') + x'*diag(rv)*x

and then replacing the first two parenthesized expressions with the equivalent vector of portfolio
bpj values:
vp = bp*CF*bp' + x'*diag(rv)*x

A further simplification is possible. The net result of the computations in the final term is simply
to multiply each residual variance by the square of the asset's proportionate holdings, then add
the results. Far better to do this directly, that is:

x'*diag(rv)*x = (x.^2)'*rv

so that:

vp = bp*CF*bp' + (x.^2)'*rv

This set of transformations allows the computation of portfolio variance without ever computing
the covariances of the component assets! Once bp has been calculated, the portfolio's variance
can be determined with one set of operations involving an {m*m} covariance matrix (CF) and
another requiring the computation of only N products of two terms. A result well worth the
matrix algebra involved in the derivations.