Refining Portfolio Construction by Penalizing Residual Alpha - Empirical Examples

8 Pages Posted: 26 Jun 2009

See all articles by Jennifer Bender

Jennifer Bender

State Street Global Advisors

Jyh-Huei Lee

MSCI Inc.

Dan Stefek

MSCI Inc.

Date Written: June 10, 2009

Abstract

Misalignment between alpha and risk factors may create unintended bets in optimized portfolios, as shown analytically in Lee and Stefek (2008). In a March research insight, we introduced a way to mitigate this issue by penalizing the portion of the alpha not related to the risk factors, the 'residual alpha.' Here, we further illustrate this method with two signals commonly used by portfolio managers. The potential improvement from this method depends on the strategy in question, in particular the degree to which the misalignment of alpha and risk factors erodes information in optimization.

Keywords: misalignment, alpha risk factors, refining portfolio construction, penalizing, residual alpha empirical managers

Suggested Citation

Bender, Jennifer and Lee, Jyh-Huei and Stefek, Dan, Refining Portfolio Construction by Penalizing Residual Alpha - Empirical Examples (June 10, 2009). MSCI Barra Research Paper No. 2009-19, Available at SSRN: https://ssrn.com/abstract=1425619 or http://dx.doi.org/10.2139/ssrn.1425619

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

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