Refining Portfolio Construction by Penalizing Residual Alpha - Empirical Examples

Jun 1, 2009

Misalignment between alpha and risk factors may create unintended bets in optimized portfolios, as shown analytically in Lee and Stefek (2008).  In a March research insight, we introduced a way to mitigate this issue by penalizing the portion of the alpha not related to the risk factors, the 'residual alpha.' Here, we further illustrate this method with two signals commonly used by portfolio managers. The potential improvement from this method depends on the strategy in question, in particular the degree to which the misalignment of alpha and risk factors erodes information in optimization.