The Case for Causal Factor Investing

16 Pages Posted: 15 Apr 2024

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

Alex Lipton

Hebrew University of Jerusalem; Massachusetts Institute of Technology (MIT)

Vincent Zoonekynd

Abu Dhabi Investment Authority

Date Written: March 27, 2024

Abstract

Researchers use factor models to obtain unbiased estimates of the premia harvested by assets exposed to certain risk characteristics. These estimates are unbiased only if the factor models are correctly specified. Choosing the correct model specification requires knowledge of the causal graph that characterizes the underlying data-generating process. However, following the current econometric canon, factor researchers choose their model specifications using associational (non-causal) arguments, such as the model’s explanatory power, instead of applying causal inference procedures, such as do-calculus. As a result, factor investing models are likely misspecified, and the estimates of risk premia are biased. This paper explains the dire consequences of factor investing’s specification errors, and calls for the need to rebuild the discipline under the more scientific foundations of causal factor investing.

Keywords: Causal inference, causal discovery, confounder, collider, factor investing, p-hacking, underperformance, systematic losses.

JEL Classification: G0, G1, G2, G15, G24, E44.

Suggested Citation

López de Prado, Marcos and López de Prado, Marcos and Lipton, Alex and Zoonekynd, Vincent, The Case for Causal Factor Investing (March 27, 2024). Available at SSRN: https://ssrn.com/abstract=4774522 or http://dx.doi.org/10.2139/ssrn.4774522

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

Alex Lipton

Hebrew University of Jerusalem ( email )

Mount Scopus
Jerusalem, Jerusalem 91905
Israel

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

Vincent Zoonekynd

Abu Dhabi Investment Authority ( email )

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

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