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I'm taking a course 'AI for trading' in udacity, and there is a part I really want to make sure. The lecture keeps teaching me that there are alpha factors (driver of return) and risk factors (driver of variance) and it also says that alpha factors can turn into risk factors. I've heard that there is a joke between quant 'Your alpha factors are my risk factors'

As I study more about factors, it seems that there is no difference between alpha factors and risk factors. Because, by taking risk factors, I mean by making ourselves exposed to those certain risks, we are getting risk premium which is 'alpha' itself. It seems that risk factor and alpha factor are like 2 sides of a coin. It can be flipped anytime. Momentum, Value, Quality factors which were thought to be alpha factors are labeled as 'risk factor' by BARRA.

I cannot understand why they keep distinguishing alpha factors from risk factors. However, it seems that what I'm confused about now also made other people confused in the past. I read the paper 'Do risk factors eat alpha factors?' by JH Lee and D Stefek in The Journal of Portfolio Management, Summer 2008 and it discussed the potential problem we can get when we use similar factor both as alpha factor and risk factor. And the problem was called 'Factor Alignment Problem (FAP)' there. Is this a problem which should be dealt seriously when we try to divide factor into alpha and risk factors?

How does this all procedure work in real world? I wonder if quants even really use the concept 'alpha factors' or they just think the only factor is 'risk factor'. Moreover, do they concern about 'Factor Alignment Problem'?

As an undergraduate student from Korea, sorry if my grammar is bad and hard to read. But I really want to make it clear. Thank you

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Your argument breaks in this line Because, by taking risk factors, I mean by making ourselves exposed to those certain risks, we are getting risk premium which is 'alpha' itself.

Market won’t always give you a premium over risk free rate for taking any kind of risk. Some factors have a researched premium attached to them, some don’t. A perfect example of this is High Beta Stocks, it was a long held belief that stocks with higher beta aka higher risk, will in the long run provide you with a premium over the market. But that’s not true always, there has been quite a few studies on premium of the Low volatility factor, which essentially says the opposite.

Also I believe the treatment of risk vs return factors is on the discretion of the investor. AQR uses value as a return driver, but some other hedge funds treat it as risk, I think it comes down to the investor whether he wants to diversify away from the more “crowded” factors. Also if you’re charging 2/20 and your portfolio is mostly driven by the common factors like value or momentum, why would anyone pay you fees when they can get the same exposure from factor indices

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    $\begingroup$ Thank you for your answer. Right I was missing the point regarding to risk premium. Not all risk factors give us risk premium and one of the examples is 'Low Vol'. So, high beta=high risk but no risk premium. If so, and if it is a reality, where does the premium actually come from? Is it still rational to think premium comes from risk and low vol is just an exception or do we have to think of source of premium in totally different way rather than risk? $\endgroup$
    – geonhwa
    Feb 18, 2021 at 10:37
  • $\begingroup$ @geonhwa They call it the low volatility “Anomaly”, so for traditions finance literature, this is still an exception. But even if a risk factor is not behaving exactly opposite to how it should, returns for it can get diminished and statistically insignificant over time due to crowding effect. As for the question “where does premium come from?”, it’s a very good question, but I don’t think I have a proper answer, maybe someone else can comment regarding that. $\endgroup$ Feb 20, 2021 at 2:37
  • $\begingroup$ @geonhwa Also I believe the treatment of risk vs return factors is on the discretion of the investor. AQR uses value as a return driver, but some other hedge funds treat it as risk, I think it comes down to the investor whether he wants to diversify away from the more “crowded” factors. Also if you’re charging 2/20 and your portfolio is mostly driven by the common factors like value or momentum, why would anyone pay you fees when they can get the same exposure from factor indices $\endgroup$ Feb 20, 2021 at 2:44
  • $\begingroup$ Thank you so much for your answers. Your second comment helped me a lot and I think I should find some articles or papers regarding to the source of premium. Factor approach always makes me exciting because of the belief that I can solve the market with a 'factor' although it might be impossible to get alpha from common well -known factors $\endgroup$
    – geonhwa
    Feb 21, 2021 at 7:51
  • $\begingroup$ @geonhwa Common well known factors sometimes can provide alphas, atleast that’s what some funds and researchers think, the reason for that is various asymmetries that cannot be arbitraged away, I’d refer you to the paper “Value-Momentum everywhere” by AQR and NYU for detailed research on this topic. But again as I mentioned in my last comment (which I’m gonna add to the answer), it’s very subjective depending upon investor views and preferences. $\endgroup$ Feb 21, 2021 at 9:43

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