A Primer on Factor Investing

Factor investing aims to capture known, persistent, and large enough risk premia associated with systematic market inefficiencies (behavioral finance explanation) or systematic sources of risk (efficient market hypothesis explanation). In simple terms, factors decompose the beta and leave the alpha as the only unexplained source of excessive returns, attributable thus to the skill of the portfolio manager.

While factors have become the foundation of investing, it is increasingly difficult to observe these factors. With a nascent market like crypto, it becomes imperative that we identify and successfully extract targeted factors driving our asset returns. In this article, we come up with a three-risk factor framework, which involves identification: based on economic justification, observable and resistant return patterns, longevity, robustness, and cost-effective implementation. This is followed by a rationale framework by which asset returns are driven by systematic risk that reflect compensations for providing insurance, exploit market inefficiencies due to persistent investor behavior biases and accommodate structural market imbalances. Lastly, we have a factor extraction framework which includes idiosyncratic factors, macro factors and statistical factors. 

Download the paper for a discussion of ways to identify risk factors in crypto portfolios.

‍*Note: Cloudwall and the technology behind its Serenity System were acquired by Talos in April 2024. Learn more.