9 – M4 L1B 09 Risk Factors V Alpha Factors Part 3 V1

Another descriptive attributes of common risk factors, is that they are well known by the investment community. This is not just a descriptive attribute, it also affects how risk factors drive price movements. When most of the investors in the market understand how a factor drives the price movement of a stock, then it’s unlikely that anyone will gain a competitive advantage in generating higher than expected returns based on that factor. Why is that? Because investors who are seeking to maintain a competitive position will monitor the movements of these risk factors, and we’ll adjust their portfolios in response to changes in these factors. Researchers have looked into how the performance of funds that use particular factors declines after those factors are widely published in academic papers. For example, the findings that small-cap stocks tend to have higher returns than large-cap stocks is also known as the size effect. Research that details this effect was first published in 1981. A mutual fund was actually created to make use of the size factor and it was called the dimensional fund advisor small company portfolio. In a study conducted in 2003, researchers showed how this particular funds performance after the 1981 publication, no longer generated abnormal returns based on the size factor. One likely explanation, is that the act of publishing the size factor and its ability to generate abnormal returns, made the size factor well-known to practitioners at investment funds. The practitioners then acted on this knowledge and over time, traded away this mispricing. That is one consequence of being risk factors. They’re not likely to be used to enhance the portfolio return. In other words, risk factors may give an indication for how much the portfolio stocks bounce up and down like boats without sails, moving up and down with the ocean waves. However, just as a boat without sales can’t drive its average position in a particular direction, an investor won’t use risk factors to drive their returns in a particular direction. To summarize the idea, we say that risk factors are drivers of portfolio variance, but not drivers of the portfolio’s mean return.

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