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Inherent Misspecification of Factor Models?

Steve LeCompte | | Posted in: Big Ideas, Investing Expertise

Do linear factor model specification choices inherently produce out-of-sample underperformance of investment strategies seeking to exploit factor premiums? In their January 2024 paper entitled "Why Has Factor Investing Failed?: The Role of Specification Errors", Marcos Lopez de Prado and Vincent Zoonekynd examine whether standard practices induce factor specification errors and how such errors might explain actual underperformance of popular factor investing strategies. They consider potential effects of confounding variables and colliding variables on factor model out-of-sample performance. Based on logical derivations, they conclude that:

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