Investing 5.0—Factor Models, Algorithms, and Chasing Alpha

Abstract

The Capital Asset Pricing Model (CAPM) is an extension of mean–variance analysis that distinguishes between risk that can be diversified away and market risk, which cannot. Shortly after the efficient market hypothesis became popular, researchers began accumulating evidence of so-called anomalies—investment strategies that beat the market—and incorporating these anomalies into CAPM as additional factors. A well-known example is the Fama–French factor model. This ransacking of data for anomalies has been facilitated by the use of computer algorithms (algos). CAPM, factor models, and black-box algorithms all lure investors away from value investing because they focus on short-term price movements.