Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing

Abstract

Factor investing has failed to live up to its many promises. Its success is compromised by three problems that are often underappreciated by investors. First, many investors develop exaggerated expectations about factor performance as a result of data mining, crowding, unrealistic trading cost expectations, and other concerns. Second, for investors using naive risk management tools, factor returns can experience downside shocks far larger than would be expected. Finally, investors are often led to believe their factor portfolio is diversified. Diversification can vanish, however, in certain economic conditions, when factor returns become much more correlated. Factor investing is a powerful tool, but understanding the risks involved is essential before adopting this investment framework.

Keywords: Overfitting, Backtesting, Crowding, Data Mining, Multiple Testing, Downside Risk, Tail Behavior, Non-Normalities, Trading Costs, Bootstrapping, Resampling, Factor Zoo, Factor Investing, Value Investing, Momentum, Size, Accounting Factors, Investment, Low Beta, Accruals, Factor Portfolios, Behavioral

JEL Classification: G10, G11, G12, G20, G23, G40