Causal Factor Investing: Can Factor Investing Become Scientific?
76 Pages Posted: 15 Sep 2022 Last revised: 30 Jan 2023
Date Written: December 2, 2022
Virtually all journal articles in the factor investing literature make associational claims, instead of causal claims. Authors do not identify the causal graph consistent with the observed phenomenon, they justify their chosen model specification in terms of correlations, and they do not propose experiments for falsifying causal mechanisms. Absent a causal theory, their findings are likely false, due to rampant backtest overfitting and incorrect specification choices.
I differentiate between type-A and type-B spurious claims, and explain how both types prevent factor investing from advancing beyond its current pre-scientific stage. This article analyzes the current state of causal confusion in the factor investing literature, and proposes solutions with the potential to transform factor investing into a truly scientific discipline.
Keywords: Association, causation, causal inference, causal discovery, causal mechanism, confounder, factor investing, backtest overfitting
JEL Classification: G0, G1, G2, G15, G24, E44
Suggested Citation: Suggested Citation