Alpha and Alpha Decay in Continuous Time
Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)
Cheung Kong Graduate School of Business
May 31, 2012
This paper analyzes a modified Sharpe ratio (SR) and alpha decay (the speed of alpha losing its value) in a continuous-time model. We show that even under the mean-variance framework, SR is not a sufficient statistic. Holding SR constant, an increase in alpha decay may be associated with a big drop in performance due to a smaller intertemporal hedging benefit. A higher SR may represent worse performance without controlling for alpha decay. These results are robust in the presence of trading costs. The empirical implication is that when comparing investors' performance, we should control for their investment styles determined by the speed of their information decay. For example, fundamental investors usually use information with slow alpha decay, but statistical arbitragers usually use information with fast alpha decay. The arbitragers may achieve a higher SR but not necessarily a better performance.
Number of Pages in PDF File: 27
Keywords: Performance, the Sharpe ratio, alpha decay, intertemporal hedging benefit
JEL Classification: D11, D91, G11, C61working papers series
Date posted: May 31, 2012
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