Aug

26

 Everybody is developing new factors. Look at me, I am small fry, and I have been investing based on factors. I thought I was alone but recent hedge-fund problems have made it clear that the whole world was doing the same thing. In the world of low-frequency finance, everybody has access to the same data, is using similar tools, hence everybody is getting the same results, which are to buy certain stocks with certain risk exposures and sell some others if you fancy being long/short.

This raises the possibility that we were not paid to perform the economic function of taking risk and collecting risk premia, but merely noise investors in a crowd, with ever more money going to funds investing in the same type of stocks, then going to these stocks, increasing factor returns, confirming historical numbers, increasing allocated money, and increasing fund returns in an upward spiral.

Just riding the wave of a Ponzi scheme is not a pleasant perspective. So of course everybody is reassessing factor models.

To be fair, everybody knew he would fail in a liquidity crisis. Quoting the 2004 Wiley book, Pairs Trading, by Ganapathy Vidyamurthy:

A scenario-altering, huge macroeconomic event, for instance, relating to interest rates … typically manifests itself in the form of a liquidity crisis. In these situations, the covariance structure breaks down, leading to the breakdown of the model.


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