What is a key benefit of using factor model based benchmarks?

Using factor model based benchmarks offers significant advantages, particularly in performance evaluation. These benchmarks allow investors to decompose the return of an investment portfolio into various risk factors, such as market risk, size, value, momentum, and others. This decomposition enables a clearer understanding of what components of performance stem from specific risk exposures versus alpha generated by active management.

Through performance evaluation with factor models, investors can assess whether a fund manager's returns are attributed to smart investment decisions (alpha) or simply exposure to specific risk factors. This clarity is invaluable for investors aiming to judge the effectiveness of their investment strategies. By quantifying how much of the performance is due to systematic risk factors, investors can make more informed decisions about whether to retain or change a manager based on real skill rather than coincidental performance.

Additionally, using factor models enhances risk management, as investors can identify and hedge against specific risk factors affecting their portfolios. These advantages make factor model based benchmarks particularly effective for evaluating manager performance in a comprehensive and insightful manner.