Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing

35 Pages Posted: 17 Feb 2019 Last revised: 11 Apr 2019

See all articles by Robert D. Arnott

Robert D. Arnott

Research Affiliates, LLC

Campbell R. Harvey

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative

Vitali Kalesnik

Research Affiliates LLC

Juhani T. Linnainmaa

USC Marshall School of Business; National Bureau of Economic Research (NBER)

Date Written: April 10, 2019

Abstract

Factor investing has failed to live up to its many promises. Its success is compromised by three problems that are often underappreciated by investors. First, many investors develop exaggerated expectations about factor performance as a result of data mining, crowding, unrealistic trading cost expectations, and other concerns. Second, for investors using naive risk management tools, factor returns can experience downside shocks far larger than would be expected. Finally, investors are often led to believe their factor portfolio is diversified. Diversification can vanish, however, in certain economic conditions, when factor returns become much more correlated. Factor investing is a powerful tool, but understanding the risks involved is essential before adopting this investment framework.

Keywords: Overfitting, Backtesting, Crowding, Data Mining, Multiple Testing, Downside Risk, Tail Behavior, Non-Normalities, Trading Costs, Bootstrapping, Resampling, Factor Zoo, Factor Investing, Value Investing, Momentum, Size, Accounting Factors, Investment, Low Beta, Accruals, Factor Portfolios, Behavioral

JEL Classification: G10, G11, G12, G20, G23, G40

Suggested Citation

Arnott, Robert D. and Harvey, Campbell R. and Kalesnik, Vitali and Linnainmaa, Juhani T., Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing (April 10, 2019). Available at SSRN: https://ssrn.com/abstract=3331680 or http://dx.doi.org/10.2139/ssrn.3331680

Robert D. Arnott

Research Affiliates, LLC ( email )

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Campbell R. Harvey (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
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National Bureau of Economic Research (NBER)

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Duke Innovation & Entrepreneurship Initiative ( email )

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Vitali Kalesnik

Research Affiliates LLC ( email )

620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8717 (Phone)
949-325-8917 (Fax)

HOME PAGE: http://researchaffiliates.com/index.htm

Juhani T. Linnainmaa

USC Marshall School of Business ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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