Factor Models for Alpha Streams
The Journal of Investment Strategies 4(1) (2014) 83-109
27 Pages Posted: 14 Jun 2014 Last revised: 16 Jan 2015
Date Written: September 3, 2014
We propose a framework for constructing factor models for alpha streams. Our motivation is threefold. 1) When the number of alphas is large, the sample covariance matrix is singular. 2) Its out-of-sample stability is challenging. 3) Optimization of investment allocation into alpha streams can be tractable for a factor model alpha covariance matrix. We discuss various risk factors for alphas such as: style risk factors; cluster risk factors based on alpha taxonomy; principal components; and also using the underlying tradables (stocks) as alpha risk factors, for which computing the factor loadings and factor covariance matrices does not involve any correlations with alphas, and their number is much larger than that of the relevant principal components. We draw insight from stock factor models, but also point out substantial differences.
Keywords: factor model, alpha stream, style factor, cluster, optimization, covariance matrix, factor loadings, specific risk, turnover, capacity, momentum, volatility
JEL Classification: G00
Suggested Citation: Suggested Citation