Narrative Factors and Risk Models

Economic narratives drive the cross section of security returns over both long and short horizons. Quantifying the marginal impact of these narratives into portfolios represents a challenge for investors, as the narratives are often correlated with fundamental characteristics. This article develops a closed-form framework to incorporate quantitative measures of narrative or thematic intensity into a conventional risk model. The authors empirically demonstrate the bias that can arise when these factors are omitted using examples from the US equity market.