Why Has Factor Investing Failed?: The Role of Specification Errors
34 Pages Posted: 18 Jan 2024 Last revised: 12 Feb 2024
Date Written: January 18, 2024
P-hacking is a well-understood cause of false positives in factor investing. A far less studied cause is factor model specification choices. We prove that specification errors cause factor strategies to underperform and potentially yield systematic losses, even if all risk premia remain constant and are estimated with the correct sign. The erratic performance of factor investing strategies is better explained by specification errors than by time-varying risk premia. The implication is that specification errors are more common and dangerous to factor investors than previously thought. We also show that standard econometric practices cause researchers to over-control for colliders, increasing the likelihood of adverse outcomes. To our knowledge, this is the first study that connects specification errors, factor model selection practices, underperformance and systematic losses through a causal mechanism. These findings challenge the scientific soundness and long-term profitability of the current (associational, casual, non-causal) multi-trillion-dollar factor investing industry. To overcome these pitfalls, academics and practitioners should rebuild the financial economics literature on the more scientifically rigorous grounds of causal factor investing.
Keywords: Causal inference, causal discovery, confounder, collider, factor investing, p-hacking, underperformance.
JEL Classification: G0, G1, G2, G15, G24, E44.
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