Journal Papers

Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing

By Campbell Harvey Rob Arnott Vitali Kalesnik Juhani Linnainmaa

FEBRUARY 2019 Read Time: 30 min


Alice's Adventures in Factorland


Blunder 1: Exaggerated Expectations

Blunder 2: Naïve Risk
Management Assumptions


Blunder 3: Diversification Vanishes When You Most Need It

Factor investing has failed to live up to its many promises. Its success is compromised by three problems that are often underappreciated by investors. First, many investors develop exaggerated expectations about factor performance as a result of data mining, crowding, unrealistic trading cost expectations, and other concerns. Second, for investors using naive risk management tools, factor returns can experience downside shocks far larger than would be expected. Finally, investors are often led to believe their factor portfolio is diversified. Diversification can vanish, however, in certain economic conditions, when factor returns become much more correlated. Factor investing is a powerful tool, but understanding the risks involved is essential before adopting this investment framework.

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Partner, Chairman of the Board
Partner, Director of Research for Europe
Partner and Senior Advisor