Building on decades of factor research
In an idealized world, risk factors should be independent of each other, yield positive risk premia, and form a complete set that spans all dimensions of risk and explains the systematic risks for assets in a given class. In practice, these requirements hold only approximately, and there are important correlations between different factors. For instance, momentum is often stronger among smaller firms (Hou, Xue, and Zhang, 2015). We will show how to derive synthetic, data-driven risk factors using unsupervised learning—in particular, principal and independent component analysis —in Chapter 13, Data-Driven Risk Factors and Asset Allocation with Unsupervised Learning.
In this section, we will review a few key factor categories prominent in financial research and trading applications, explain their economic rationale, and present metrics typically used to capture these drivers of returns.
In the next section, we will demonstrate...
