Don’t Factors Still Have An Effect On Alpha Markets Across Equities Sectors?
I understand that equity MM shops (Citadel etc) try to run close to factor neutral. My question is, don’t factors themselves influence the market for alpha in a given sector? One way to think about it is the expansion of market cap (i.e. liquidity) in a sector is obviously advantageous to the alpha market in that sector because friction costs go down. So a couple of questions: Are MM equity PMs always rooting for their sector to be hot? Even if your factor neutral aren’t your future return streams stilldetermined by factors?
I guess an example would be energy correlation with interest rates. In broad strokes, traditional energy does better when interest rates are higher, and worse when interest rates are lower relative to overall market. Clearly this has an effect on the whole because Citadel fired entire Energy team in late 2020/early 2021, and yet they’re still back with a vengeance now in energy equities. Which makes me think it’s still factors, not just pure PM grit/intelligence, that drives these return streams even in the market-neutral model
It's precisely because factors by definition will always have an effect on alpha, that certain products will try to run factor neutral. If you assume that factors drive alpha, then LPs can just gain exposure to those factors by themselves. Why hire an active PM? Because these pods seek to deliver uncorrelated returns.
Then there are products that sit in the middle between factor neutral, and passive management - i.e., factor funds, e.g., AQR's many products. These funds fully presume that factors drive alpha, and they run their funds with a philosophy of active factor management, thus harvesting alternative beta. Presumably, there will be LPs that don't have the sophistication (yet) to gain exposure to factors themselves, hence these funds are the solution for them.
Lmk if this answers your question.
My question was taking it almost a step further and presuming that even if you’re factor neutral, factors can still affect your performance. The one clear way to me is compression of market cap leading to higher friction costs if your sector overall performs poorly because of some broad trend in the market place. Also like each equities sector has it’s own “alpha market”—define that as the IQR of returns in the sector and maybe even try to normalize the factor weightings of the individual companies (if that would be possible). I would presume this alpha market would fluctuate wildly YoY by sector, and quite possibly this alpha market could fluctuate based on factors themselves. Might be off the deep end with this question and I think it might rest on the fact that factor weightings are dynamic
Alright. Seems to me that you're thinking of broad factors instead of clearly academically defined, micro-founded risk factors such as the infamous value and size factors.
To that, some PMs take a lot of care to correct for unintended bets. This means that even after you've put together a well-constructed portfolio (whether factor neutral or not), unintended bets will almost inevitably exist in the portfolio. Unintended bets are also called incidental bets by some people. For example, say you construct a global momentum portfolio (or whatever), but it turns out that most of the momentum names screened for globally, all turn out to be Chinese tech, because for some reason Chinese tech is having a MOM run. You're now inadvertently exposed to Chinese (tech) risk. You have to go back, revise, and control for this unintended risk, for example, controlling for the exposure to the risk of the compression of market cap you had in mind.
For interest, risk analysis classifies active bets into inherent bets, intended bets, and unintended bets. Inherent bets are basically systematic risk, intended bets are your factor tilts (so if factor neutral, no intended bets), and then your unintended bets that you have to control.
Michelle Aghasi has a lot to say about this
Factors are hueristics to describe returns, they are a measurement and not a driver.
Yes, PMs want their sector to have more market cap and trading volume, because these are key inputs to determine max position size and thus size of your book. From my experience, factor neutral alpha is most ideal when generalists/LO money is flowing into/out of a sector. When it’s all gone, it’s a just a pod knife fight of informed investors, when it’s all there things trade more on narrative and (often wrong, but simple to assess ‘big picture’ theses). As a short focused analyst paid on alpha, I would prefer that the market go up 100% and my book does -50% pnl, cause then my book is larger compared to market flat and I make 50% +ve pnl. A surprising amount of funds still don’t think like this - those funds are stupid
No. They are both. (Can use them for performance evaluation obvs, and they literally drive returns)
Put simply, risk factors are what the name implies - systematic sources of risk. Because these factors carry risk, that's why the returns are not arbed away (and remain in the market). Limits to arbitrage for many investors.
The biggest, OG risk factor is just market beta which everyone knows about. Because equities carry risk, that's why they bear an equity risk premium. The risk drives the return. Risk-averse investors demand a risk premium, which pushes down the price which drives the higher return of risky assets and risk factors.
Put even simpler - there's a 100-dollar bill on the floor but there's a mad bulldog guarding it. You run the risk of getting your hand snapped off if you try to pick it up. That's why the bill stays on the floor - the dog (the risk) ensures it stays there, the dog drives the return
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