Markets Don't Work as Well as We Thought

One of the big unanswered questions in the finance world is: Do returns reflect risk or mispricing? Defenders of the efficient markets hypothesis say that you can’t get higher returns without taking more risk, while behavioral finance says that there are often unexploited anomalies that will let wise, patient or deep-pocketed investors beat the market without taking on more risk.

This debate is very relevant to the use of factor models. These models, which are used to design investment portfolios with specific characteristics, have been one of the most successful methods to come out of academic finance in the past 40 years. Most financial institutions, and all of the sophisticated ones, now use factor models to measure their risk. Many also use them to optimize their returns. For example, so-called smart beta investing strategies, one of the most popular investing fads of the past decade, are mostly just the application of factor models. You can also now buy exchange-traded funds that take advantage of a wide array of factors.