Factor investing has failed to live up to its press. Its success is compromised by three risks that are often underappreciated by investors.
- First, investors are led to develop exaggerated expectations about factor performance due to data mining, crowding accompanied by rising valuations, underappreciated trading costs and other concerns.
- Second, factor returns are prone to downside shocks far larger than investors might expect, for those using naïve risk management tools.
- Finally, investors are often led to believe that their factor portfolio is diversified. However, that diversification can vanish in certain economic conditions, when factor returns become much more correlated.
Before investing, it is essential to understand the risks. Our presentation measures the gravity of each of these types of risks.