Demonstration 1 of 1
Raw and neutralized features, scored against raw and factor-neutral returns
When does removing factor exposure from the features help the score, and when does it cost correlation?
Raw features carry exposure to the factor, and the model learns that exposure pays because it did during training. While the premium persists, that exposure earns correlation on raw returns. When it fades or flips, the same exposure turns into a loss, and the daily correlation swings with the factor. Neutralized features give up the exposure bet in every regime and keep only the alpha signal, which is all a factor-neutral metric can reward.
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x is a feature, b the asset's exposure to the factor, and the neutralized feature x* subtracts a fraction q of the day's regression of x on b. The score is the mean over dates of the Spearman correlation between a prediction and a target.
Predict first. If the factor premium flips sign after training, what happens to the raw-feature model's correlation with raw returns?
Choose an example
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Constructed example: eight seeded synthetic markets of 120 assets and a Ridge model, measured by the chapter activity.
Calculated values
- Raw features, raw returns
- -0.186
- Neutralized, raw returns
- 0.061
- Raw features, neutral returns
- 0.055
- Neutralized, neutral returns
- 0.072
- Cost of neutralizing (raw returns)
- -0.247
With a premium of -0.50 in the scored period (0.5 in training), raw features score -0.186 against raw returns and fully neutralized features 0.061, so 0.061 - (-0.186) = 0.247 is what neutralizing gains there. Against factor-neutral returns the scores are 0.055 and 0.072. The daily correlation on raw returns has a standard deviation of 0.230 with raw features and 0.082 with neutralized ones.
Worked steps
- Cost of full neutralization on raw returns: -0.186 - 0.061 = -0.247.
- Gain on factor-neutral returns: 0.072 - 0.055 = +0.017.
- Half neutralization on raw returns: -0.087, between the two ends.
- Daily swing on raw returns, raw features minus neutralized: 0.230 - 0.082 = +0.148.
Use the idea
Read the official metric before choosing a representation: score raw and neutralized versions of the same model on the exact target and compare them on later periods, not only on the training regime.
Where the conclusion applies
Constructed markets with one factor, a static beta per asset and an alpha signal that does not change; Ridge regression stands in for any model and eight markets give the means. Exposure here is observed without error, which is generous: with a noisy exposure estimate, neutralization would remove less. The premium in the scored period is set by hand to show the regimes. The result concerns the scoring target, and is not a claim about any real competition or about trading profit.
Check your understanding: Neutralization lowers the score on raw returns when the premium persists. Does that make it the wrong choice?
Chapter 53 source: section "Feature Neutralization: Removing Market Exposure".