The Fundamentals of Fundamental Factor Models (June 2010)

This paper highlights the fundamental-based origins of the factor models used at Barra. Barr Rosenberg and Vinay Marathe (1976) first discussed the theory that the effects of macroeconomic events on individual securities could be captured through microeconomic characteristics such as industry membership, financial structure, or growth orientation. This linkage between macroeconomic events and microeconomic (or fundamental) characteristics lies at the heart of the factor model. We discuss the intuition behind a fundamental factor model, showing how it is linked to traditional fundamental analysis, and point out the insights these models can provide. Our goal is to highlight the complementary role of the fundamental factor model to traditional security analysis.