08. Risk Factors v. Alpha Factors

Risk Factors v. Alpha Factors

In general, risk factors are significant contributors to the variance of asset returns, and less predictive of the mean of returns. Risk factors are identified to control risk. One way to do control an asset's exposure to a risk factor is to hold an equal amount long as short. For instance, a dollar neutral portfolio with equal amounts long and short is controlling for risks that the overall market may move up or down.

In general, factors that are significant in describing the mean of asset returns can be candidates for alpha factors. Alpha factors are used to give some indication of whether each stock in the portfolio may have positive expected returns or negative expected returns. For example, a former alpha factor was the market capitalization of a stock. Small cap stocks tend to have higher future returns compared to large cap stocks.