Benchmarks based on factors or models are types of benchmarks that specify a set of factors to use as a reference. As for example according to the size of the company in which they invest, index styles or economic growth (GDP) among others.
The overall formula-based benchmark formula is as follows:
R = a + b1 F1 + b2 F2 +… + bk Fk + ε
Where R is the profitability of the benchmark, a, a zero factor that represents the performance of the benchmark if all other factors were zero, in that case the benchmark would be absolute return, b, is the elasticity by which the factor is multiplied, F the factor and ε, is the error, that is, the profitability of the benchmark that is not explained with the factor model.
The benchamark will be the portfolio that has exposure to the defined factors that are typical in the manager. The manager’s previous portfolios can be used as a guide.
It is a very useful type of benchmark when evaluating the performance of an investment. In addition, it provides a clear explanation of the style followed by the manager in question.
On the contrary, it may not be an appropriate benchmark because different factors produce different returns, if the factors are complex the data can be very difficult to obtain and focusing on some factors is not very intuitive either for the manager or for the fund investors.