10 – M4 L1B 11 How An Alpha Factor Becomes A Risk Factor Part 1 V3

Alpha factors eventually lose their performance as they become more publicly known among investors, and then eventually become risk factors. Let’s look at an analogy to help frame our discussion of how this happens. Let’s say I drive to work and I normally deal with a lot of traffic. So, I download this cool new app that tells me which lane I should choose, that will let me get to work faster. Since I’m one of the few people who has downloaded and used the app so far, I’m able to find lanes that have fewer cars and move through traffic a little bit faster than the other drivers. You can think of this app as my alpha factor, because it’s helping me improve my performance on the road. Now let’s say this app becomes really popular. So, most other drivers now use it to help them find the fastest lane. Now, when the app tells me to take a particular lane, many other drivers next to me also get the same signal, so they also choose that same lane. Many drivers actually get into the lane before or at the same time that I do, so I no longer have the ability to get ahead of the other drivers. Moreover, since everyone is following this app, the app is now driving the variance of these cars on the road. You can imagine many cars now constantly changing lanes concurrently, as a group like a school of fish, and yes, I just used a fish analogy to explain the car analogy, which in turn I’m using to explain alpha factors. We can now think of this driving app as a risk factor, because it is driving the movement of many cars, and therefore, the variance, but is no longer helping any of us improve our individual performance.