Causal Network Representations in Factor Investing

Abstract

This paper explores the application of causal discovery algorithms to factor investing, addressing recent criticisms of correlation-based models. We create novel causal network representations of the S&P 500 universe and apply them to three investment scenarios. Our findings suggest that causal approaches can complement traditional methods in areas such as stock peer group identification, factor construction, and market timing. While causal networks offer new insights and sometimes outperform correlation-based methods in terms of risk-adjusted returns, they do not consistently surpass traditional approaches. The causal method though shows promise in identifying unique market relationships and potential hedging opportunities. However, its practical implementation presents challenges due to computational complexity and interpretation difficulties. Our study demonstrates the potential value of causal discovery in factor investing, while also identifying areas for further research and refinement.

Keywords: causal discovery, factor investing, asset pricing, financial networks, market timing

JEL Classification: C32, C38, G11, G12