Alpha Uncertainty Principle

Abstract:     
Alpha Uncertainty Principle introduces a new relationship between alpha potential and alpha uncertainty. Alpha uncertainty increases with degrees of freedom used in active management. This uncertainty cost has been largely ignored by investors. As a result free put options have been written to active managers, which if widespread could have systemic effects. The uncertainty principle introduces a trade-off that is shown to enable a new approach to a number of practical investment problems including: role of active management in asset allocation and optimal tracking error. The principle is shown to lead to the concept of Alpha Efficient Frontier.

Keywords: Alpha, Active Management, Asset Allocation, Hedge Funds

JEL Classifications: G1, G11

Working Paper Series