Please explain like I am a high school student: The Dawn of Causal Factor Investing
Answering the “why” question is more than an academic pursuit. Causal factor theories would be highly beneficial to all types of investors, for several reasons: First, efficiency: causal models attribute risk and performance correctly. With proper risk and performance attribution, researchers can build portfolios that concentrate exposure on rewarded risks and hedge unrewarded risks. Second, interpretability: every institutional investor owes it to its beneficial owners to explain why they may have to delay their plans (e.g., retirement). Third, transparency: a causal graph makes explicit all the assumptions involved in a theorized mechanism. Investment strategies based on causal theories are not black-boxes. Fourth, reproducibility: a causal explanation reduces the chances of (i) random variation (type-A spuriosity), by confining the search space to plausible theories, and (ii) noncausal association (type-B spuriosity), by providing some assurances that the phenomenon will continue to occur as long as the mechanism remains. Fifth, adaptability: the profitability of investment strategies founded on associational relations relies on the stability of the joint distribution’s parameters, which in turn depends on the stability of the entire causal graph (variable levels and parameters). In contrast, investment strategies based on causal relations are resilient to changes that do not involve the parameters in the causal path (see Section 6.4.2.1). 

This makes causal investment strategies more reliable than associational investment strategies. Sixth, extrapolation: only an investment strategy supported by a causal theory is equipped to survive and profit from black-swan events, by monitoring the conditions that trigger them (e.g., liquidity strategies based on the PIN theory performed well during the 2010 flash crash). Seventh, surveillance: the validity of a causal mechanism can be assessed in more direct and immediate ways than estimating the probability of a structural break in performance. This attribute is of critical importance in a complex dynamic system like finance: (i) an investor in a causal factor investing strategy may be able to divest when the causal mechanism weakens, before losses compound to the point that a statistical test detects a structural break; (ii) causal mechanisms enable factor timing, dynamic bet sizing, and tactical asset allocation. Eighth, improvability: causal theories can be refined, as a researcher learns more about the mechanism responsible for the observations. The fate of investment strategies based on causal theories is not unavoidable decay toward zero performance. These are all attributes that make an investment strategy appealing and trustworthy, and that current factor investments lack.

Financial economists’ adoption of causal inference methods has the potential to transform investing into a truly scientific discipline. Economists are best positioned to inject, make explicit, and argue the extra-statistical information that complements and enriches the work of statisticians. Financial economists interested in causal research would do well in partnering with noncommercial asset managers, such as sovereign wealth funds and endowments. These institutional investors are not conflicted by commercial interests, and their objectives are aligned with their beneficial owners.

The new discipline of “causal factor investing” will be characterized by the adaptation and adoption of tools from causal discovery and do-calculus to the study of the risk characteristics that are responsible for differences in asset returns. Every year, new alternative datasets become available at an increasing rate, allowing researchers to conduct natural experiments and other types of causal inference that were not possible in the twentieth century. Causal factor investing will serve a social purpose beyond the reach of (associational) factor investing: help asset managers fulfill their fiduciary duties with the transparency and confidence that only the scientific method can deliver. To achieve this noble goal, the dawn of scientific investing, the factor investing community must first wake up from its associational slumber.