Alpha-Risk Factor Misalignment

Jan 15, 2013

Portfolio managers have long worried that discrepancies between risk and alpha factors may somehow detract from the performance of their optimized portfolios. This paper presents a comprehensive overview of alpha-risk factor alignment and its consequences, showing how penalizing the residual alpha may help reduce the unintended bets resulting from misalignment. However, we also illustrate that correcting for misalignment may not always be necessary and can sometimes be counterproductive—the need for corrective action depends on the information content of residual alpha. Improvement in Information Ratios was achieved in just over half of the cases we examined and the average magnitude of improvement was small.