Do Risk Factors Eat Alphas?

Apr 1, 2008

Portfolio managers worry that discrepancies between risk and alpha factors may create unintended biases in their optimized portfolios. We analyze the ramifications of using different factor models of risk and alpha in portfolio optimization and show that aligning risk factors with alpha factors may improve the information ratio of optimized portfolios, even if doing so lowers the overall accuracy of risk forecasts. We discuss ways of modifying a risk model that may help remedy these problems.