13. How an alpha factor becomes a risk factor part 2

Alpha factors becoming risk factors

An alpha factor that is generated by internal research in a fund can help that fund seek a competitive advantage in the market. If the proprietary factor isn't yet discovered by the rest of the investment community, most others won't act on that signal when making investment and trading decisions.

Alpha factors usually lose their effectiveness over time. One possible reason is that as other funds also discover the factor, and make investment decisions based on its signal, then the above-average gains or arbitrage opportunities get diffused as they're shared by a growing number of market participants. Eventually, if a factor becomes very well known and most investors are acting on its signal, then the factor can be considered more of a risk factor.

Among quants, you may hear the joke that "your alpha factor is my risk factor," since it's up to each fund to decide whether to use a factor to control risk or to drive returns.