Refining Portfolio Construction When Alphas and Risk Factors are Misaligned

8 Pages Posted: 26 Mar 2009

See all articles by Jennifer Bender

Jennifer Bender

State Street Global Advisors

Jyh-Huei Lee

MSCI Inc.

Dan Stefek

MSCI Inc.

MSCI Inc.

MSCI Inc.

Date Written: March 9, 2009

Abstract

The misalignment of alpha and risk factors may result in inadvertent and unwanted bets that may hamper performance. Lee and Stefek (2008) show that better aligning risk factors with alpha factors may improve the information ratio of optimized portfolios. They propose four ways of modifying a risk model to reduce misalignment. Here, we discuss one way to mitigate these problems by modifying the optimization process, itself. The objective function is modified to include a penalty term on the residual alpha. In our examples, the method proposed helps to mitigate the mismatch between alpha and risk by assigning a suitable penalty to the residual alpha.

Keywords: portfolio construction, alpha risk, factors, construction, misaligned model, residual

Suggested Citation

Bender, Jennifer and Lee, Jyh-Huei and Stefek, Dan and Inc., MSCI, Refining Portfolio Construction When Alphas and Risk Factors are Misaligned (March 9, 2009). MSCI Barra Research Paper No. 2009-09, Available at SSRN: https://ssrn.com/abstract=1367123 or http://dx.doi.org/10.2139/ssrn.1367123

Jennifer Bender

State Street Global Advisors ( email )

1 Lincoln Street
28th Floor
Boston, MA 02111
United States

Jyh-Huei Lee

MSCI Inc. ( email )

88 Pine Street
2nd Floor
New York, NY 10005
United States

Dan Stefek

MSCI Inc. ( email )

88 Pine Street
2nd Floor
New York, NY 10005
United States

MSCI Inc. (Contact Author)

MSCI Inc.

88 Pine Street
2nd Floor
New York, NY 10005
United States

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