Causal Factor Investing: Can Factor Investing Become Scientific?

76 Pages Posted: 15 Sep 2022 Last revised: 30 Jan 2023

See all articles by Marcos Lopez de Prado

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Abu Dhabi Investment Authority; True Positive Technologies

Date Written: December 2, 2022

Abstract

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

López de Prado, Marcos and López de Prado, Marcos, Causal Factor Investing: Can Factor Investing Become Scientific? (December 2, 2022). Available at SSRN: https://ssrn.com/abstract=4205613 or http://dx.doi.org/10.2139/ssrn.4205613

Marcos López de Prado (Contact Author)

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates

HOME PAGE: http://www.adia.ae

True Positive Technologies ( email )

NY
United States

HOME PAGE: http://www.truepositive.com

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