Understanding Alpha Decay

Management Science, accepted manuscript

19 Pages Posted: 18 Apr 2017 Last revised: 18 Jan 2022

Date Written: January 15, 2022

Abstract

I study the importance of alpha decay for the measurement of realized and conditional expected returns in asset pricing studies. Alpha decay refers to the reduction in abnormal expected returns (relative to an asset pricing model) in response to an anomaly becoming widely known among market participants. As decreases in alpha are associated (ceteris paribus) with positive realized returns, the econometrician may misinterpret these repricing returns as evidence that the anomaly will persist in the future. Because alpha decay is generally a non-stationary phenomenon, asset pricing tests that impose stationarity may lead to biased inference. I illustrate the importance of alpha decay using the most commonly-studied anomalies in the asset pricing literature and find that the measured alpha differs from the true alpha by about 1.4% per year. I provide a simple formula to correct for this bias, and show how to incorporate alpha decay tests into the standard asset pricing toolkit.

Keywords: Anomalies, Cross-Sectional Return Predictability, Market Efficiency

JEL Classification: G00, G12, G14

Suggested Citation

Pénasse, Julien, Understanding Alpha Decay (January 15, 2022). Management Science, accepted manuscript, Available at SSRN: https://ssrn.com/abstract=2953614 or http://dx.doi.org/10.2139/ssrn.2953614

Julien Pénasse (Contact Author)

University of Luxembourg ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

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