Beta vs. Characteristics: A Practitioner's Perspective

The first part of the paper demonstrates the similarity between the beta model (a.k.a. covariance model) and the characteristics model in the ability to reduce portfolio risk. When the two models are applied to the S&P 500 stocks in the period between 1980 and 2010, one model appears better than the other for some sub-periods, but the pattern is reversed for other sub-periods. Also, the difference, when it exists, is not economically significant. In the second part of the paper, the similarity between the two models is traced back to the correlation between beta and characteristics and also the correlation between factor and the characteristics price. A Monte Carlo simulation suggests that the difference between the two models is unlikely to increase substantially even if the underlying correlation structure changes unfavorably.