In the years following the financial crisis, the investment industry has come to view enterprise risk management (ERM) as an essential part of the portfolio management workflow. It is now widely accepted that superior investment performance is the result of not only high quality return forecasting models, but also of careful and diligent analysis, monitoring, and management of investment risk.
Linear factor models occupy a special place among the variations of risk models available in the market. They are simple, able to decompose portfolio risk into a set of economically sound risk factors, and flexible enough to incorporate sophisticated volatility and correlation modeling techniques. This allows for risk decomposition precisely aligned with the variables managers use for portfolio construction and optimization.