## 12 Jul Takeaways From Jason Hsu’s “The Whole Story: Factors + Asset Classes”

**On backtesting**

When one runs a backtest to assess a signal that is, in fact, uncorrelated with future returns, the probability of observing a t-stat greater than 2 is 2.5%. However, when thousands upon thousands of such backtests are conducted, the probability of seeing a t-stat greater than 2 starts to approach 100%.

To establish a sensible criterion for hypothesis testing in the age of dirt-cheap computing power, we need to adjust the t-stat for the aggregate number of backtests that might be performed in any given year by researchers collectively. Recognizing that there are a lot more professors and quantitative analysts running a lot more backtests today than 20 years ago, Cam argued that a t-stat threshold of 3 is certainly warranted now.

Dr. Feifei Li requires a t-stat greater than 4 from our more overzealous junior researchers.

**On traditional factors**

Cam also concluded that outside of the market factor, the other factors that seem to be pervasive and believable are the old classics: the value, low beta, and momentum effects. The newer anomalies are most likely results of datamining.

Dick concluded that momentum is almost certainly a free lunch: it creates excess returns without exhibiting any meaningful covariance with true underlying risks.

**On factor investing**

Encourages investors to think more about factors and less about asset classes (Ang, 2014). Andrew argues that factors are like nutrients as asset classes are like meals.

I also wish to offer caution on the emerging trend toward “pure” factor portfolios. Going back to the food/ nutrient analogy: would one consider it wise to replace traditional home cooked meals with a chemical cocktail of vitamins and nutritional supplements? Similarly, would factor portfolios constructed from long–short portfolios based on complex quantitative models provide more effective and complete access to the essential drivers of long-term returns than asset classes?

**On CAPE/Shiller-PE**

Essentially, the economy appears to support high CAPEs when there is modest inflation (about 2% to 3%) and a moderate real interest rate (3% to 4%). As the rates of inflation and real interest diverge from these benign zones, the supportable CAPE declines drastically. The low inflation and near-zero real interest rate suggest a much lower CAPE for the U.S. economy than current equity prices reflect (CAPE > 25). This might presage downside U.S. equity price risk.

## No Comments