What is a "factor portfolio"?

Question

What does it mean and what is it's role in equity management?

Answer 1

Imagine you have a portfolio containing a number of stocks. The performance of the portfolio is not random, but depends on external influences or factors, like changes in interest rates, market indices, oil price, inflation....

A factor portfolio is a portfolio constructed in such a way, that the beta between that factor and the portfolio is (close to) 1, but is weakly correlated with other factors. Exemple: a portfolio that changes 1% in value as the oil price changes 1%, but is not sensible to other factors.

In practice you can construct such portfolios using past performances, but of course the correlations are never fixed in time. But one can come close juggling with options.

Answer 2

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