Factor Models Actually Improve Your Alphas

Introduction

Most portfolio managers treat their factor model as infrastructure - something you license from a vendor and forget about. That is a mistake. Your factor model is not JUST risk management plumbing. It is the lens through which you view the market, and the quality of that lens directly determines how much alpha you can find.

The point today is simple: factor models are a denoising technique. They partition returns into “stuff that does not matter” (systematic factor exposure) and “stuff that does matter” (idiosyncratic returns where alpha lives). The better you model the systematic part, the cleaner the residual - and the cleaner the residual, the easier it is to find tradeable alpha.