Finding Smart Beta in the Factor Zoo

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Abstract

When we were in the Ph.D. program at UCLA, we were taught the four-factor model in our asset pricing class. The world was simple; there were the market risk factor and the value, small-cap, and momentum return factors. 2 The three non-market factors car-ried juicy return premia that could be had by investors willing to diversify into non-market exposures and exploit retail investors' behav-ioral biases. Fifteen years later, we are shocked to learn that some quant shops now use an 81-factor model to build equity portfolios. This infla-tion in factors has certainly made us feel inadequate and has potentially eroded the real value of our paper diploma. Understand-ably, we are concerned with the relentless onslaught of shiny, exciting, and sexy new factors introduced by bright-eyed, bushy-tailed young financial engineers. 3 Frankly, we expected the number of " accepted " factors to decrease rather than explode over time. We expected that at least one of the three documented anomalies would be revealed as a fluke—a data artifact that would disappear with better qual-ity international data and with additional decades of out-of-sample data following the original discovery.

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