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Key Ideas
- The questions you might ask your doctor or pharmacist about a drug apply to factor investing too. By asking them, we believe you’ll view factor exposures beyond their advertised claims of compensated risks; rather, you may find the need to diversify – even limit – your exposure to them because of the uncompensated risks they represent.
- We observe that the alpha potential for factors is fragile and current applications are constrained in two important ways. First, investors have overused the factors that were easy to discover. Second, statistical analysis used to improve or discover factors has become increasingly less productive.
- A better use for factors by investors today is to help evaluate their systematic risks, which threaten more than just factor investors. Other investors must also take notice of overcrowding risks, and step aside when hot trades roil the markets.
- By decomposing factor performance into stock- and portfolio-level effects, we can understand exposure to factors’ diluted alpha potential while carefully managing their uncompensated risks. Both serve our collective goal: better risk-adjusted outcomes.
The popularity of factor investing – like the overuse of antibiotics – appears to be at a critical stage. While investors’ adoption of factors has never been broader, their concerns about the effectiveness of factor investing are increasing. In our opinion, asking the right questions about factor investing has never been more justified.
