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Are Your Factors Aligned?

Many institutional investors develop proprietary return forecasting models, but use third-party/alternative models such as the MSCI Global Equity Total Market Model 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. This Research insight describes a practical process for detecting and addressing misalignment between alpha and risk factors.