Many institutional investors develop proprietary return forecasting models, but use third-party/alternative models to measure risk and transaction costs. While there may be a significant overlap between the factors used in alpha and risk models, at times they may be misaligned.
For managers who optimize their portfolios, the optimizer will tend to amplify the component of alpha that is not aligned with the risk model; this may lead to unintended portfolio exposures and unnecessary trading. Both of these unintended consequences may impair portfolio performance.
As investors increasingly adopt modern risk models, such as the MSCI Global Equity Total Market Model, the need to understand the alignment between risk factors and the alphas used in portfolio construction grows. These models include several Systematic Equity Strategy (SES) factors that have been important sources of systematic returns. These factors also play an important role in forecasting and explaining risk in active equity portfolios.
We have created a practical process for detecting and addressing misalignment between alpha and risk factors to be used quantitative portfolio construction. Portfolio managers have a choice when addressing misalignment:
- Remove overlapping risk factors from the risk model
- Replace overlapping risk factors with the alpha factors in the risk model
- Penalize residual alpha in optimization process
- Rescale alphas in order to align with risk model
While all four solutions may offer remedies for misalignment, only Solutions 3 and 4 improved risk-adjusted performance and risk forecast accuracy in three portfolio construction settings.
For portfolios where residual alphas may bear incremental systematic risk not captured in the risk model, Solution 3 may offer the best choice. Where it is believed that residual alphas are purely stock-specific, Solution 4 may be appropriate.
Active style risk represents a significant part of total active risk for the vast majority of all U.S. equity mutual funds, including those that are quantitatively driven.
Source: MSCI Peer Analytics as of April 30, 2015
Read the paper, “Are Your Factors Aligned?”