A hedge fund pursuing a trading strategy based on fantasy goes broke. A market researcher who does it, on the other hand, is apt to get tenure.
That in a nutshell is the argument in a new paper by Duke University theoretician Cam Harvey, who says that way too many academic projects that go looking for trading edges succeed in finding them. In reality, only a handful stand up outside the walls of academia.
By Harvey’s tally, more than 400 factors — strategies that slice and dice stocks by things such as size, volatility or valuations, and which are supposed to beat the market — have been published in top journals since the 1960s, with roughly half of them discovered in the past decade.
“It just didn’t make any sense to me. It’s really hard to find something that outperforms a market,” Harvey said in a phone interview. “How many factors can there credibly be? Well, to me, it’s maybe up to a couple of dozen.”
Add on top implementation costs that eat into performance and the fact that some factors generate too small extra returns, and the number of true gems in the quant world is likely significantly lower, he says.
Still, the performance of theoretical factors doesn’t take into account costs related to transactions or short selling. And evidence of data overfitting exists in asset management, Harvey says, pointing to a few recent ETF studies by other researchers that showed stellar returns during the years leading up to their launch only to languish afterward.
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