A 'Smart' Alpha Overlay
13 Pages Posted: 17 Sep 2015
Date Written: September 15, 2015
The recent surge of interest in so-called smart beta strategies originates from the apparent shortcomings of both traditional benchmarks and active management. Yet not all investors want to follow passive indexing, no matter how smart. Recent literature has tried to reconcile the need for integrating active views in a given benchmark with the risk discipline of the smart beta approach. In particular, Medvedev (2015) has proposed a procedure of risk optimization based on qualitative views or rankings and a prior portfolio. The current article updates that procedure by making it simpler, more robust and thus better suited for real life applications. Our aim is to present an easily implemented rule that, given a benchmark and a set of views, yields a portfolio that dominates the benchmark both in risk and return. We provide an intuitive interpretation of this algorithm as a hedging procedure where risk budgets allocated to each active view are determined on the basis of their hedging capacity. We demonstrate the working of this algorithm using the Dow Jones Large Caps equity index as an illustration.
Keywords: asset allocation, portfolio construction, alpha overlay, active views, minimum risk, expected returns
JEL Classification: C60, D81, G11
Suggested Citation: Suggested Citation