Custom v. Standardized Risk Models

TL;DR

This paper analyzes the advantages and limitations of custom versus standardized multi-factor risk models, emphasizing their suitability for different investment horizons and strategies.

Contribution

It provides a detailed discussion on when custom risk models are necessary and offers source code for computing key risk factors, highlighting their benefits over standardized models in active trading.

Findings

Custom risk models reduce noise and trading costs for short-term strategies.

Standardized models are suitable for pension and mutual funds with longer horizons.

Diversifying risk models improves P&L, reduces turnover, and increases capacity.

Abstract

We discuss when and why custom multi-factor risk models are warranted and give source code for computing some risk factors. Pension/mutual funds do not require customization but standardization. However, using standardized risk models in quant trading with much shorter holding horizons is suboptimal: 1) longer horizon risk factors (value, growth, etc.) increase noise trades and trading costs; 2) arbitrary risk factors can neutralize alpha; 3) "standardized" industries are artificial and insufficiently granular; 4) normalization of style risk factors is lost for the trading universe; 5) diversifying risk models lowers P&L correlations, reduces turnover and market impact, and increases capacity. We discuss various aspects of custom risk model building.