The Evolving Causal Structure of Equity Risk Factors

TL;DR

This paper investigates how the causal relationships among US equity risk factors evolve over 29 years, revealing a trend towards sparsity that reverses during financial crises, with implications for risk management.

Contribution

It applies advanced causal structure learning methods to analyze the dynamic causal network of equity risk factors over time, highlighting changes during market stress periods.

Findings

Causal structure becomes sparser over time during stable periods.

During financial stress, the causal network densifies, especially around the market factor.

Causal analysis provides deeper insights than correlation analysis during crises.

Abstract

In recent years, multi-factor strategies have gained increasing popularity in the financial industry, as they allow investors to have a better understanding of the risk drivers underlying their portfolios. Moreover, such strategies promise to promote diversification and thus limit losses in times of financial turmoil. However, recent studies have reported a significant level of redundancy between these factors, which might enhance risk contagion among multi-factor portfolios during financial crises. Therefore, it is of fundamental importance to better understand the relationships among factors. Empowered by recent advances in causal structure learning methods, this paper presents a study of the causal structure of financial risk factors and its evolution over time. In particular, the data we analyze covers 11 risk factors concerning the US equity market, spanning a period of 29 years at daily frequency. Our results show a statistically significant sparsifying trend of the underlying causal structure. However, this trend breaks down during periods of financial stress, in which we can observe a densification of the causal network driven by a growth of the out-degree of the market factor node. Finally, we present a comparison with the analysis of factors cross-correlations, which further confirms the importance of causal analysis for gaining deeper insights in the dynamics of the factor system, particularly during economic downturns. Our findings are especially significant from a risk-management perspective. They link the evolution of the causal structure of equity risk factors with market volatility and a worsening macroeconomic environment, and show that, in times of financial crisis, exposure to different factors boils down to exposure to the market risk factor.