Correlation without Cause

Are correlations and R-squared statistics sufficient to discover reliable connections between financial/economic variables and future asset returns? In their February 2025 paper entitled “Causal Factor Analysis is a Necessary Condition for Investment Efficiency”, Marcos Lopez de Prado, Alexander Lipton and Vincent Zoonekynd assess the consequences of factor model misspecification for portfolio optimization (maximizing expected return per unit of risk). They define risk conventionally as: (1) standard deviation of expected portfolio returns; and (2) portfolio exposure to factors, such as size, value, growth, momentum, quality, yield, low volatility, carry, liquidity or macroeconomic variables. Based on theoretical derivations, they conclude that: (more…)