Aligning Alpha and Risk Factors, a Panacea to Factor Alignment Problems?
The practical issues that arise due to the interaction between three principal players in any quantitative strategy, namely, the alpha model, the risk model and the constraints are collectively referred to as Factor Alignment Problems (FAP).
While the role of misaligned alpha factors in causing FAP is relatively easy to understand, incorporating the impact of constraints entails considerable analytical complexity that most consultants and researchers found diffcult to fathom.
A few of them have even gone to the extent of suggesting that aligning alpha and risk factors should suffice in handling FAP.
We provide a solid rebuttal to this line of thinking by demonstrating typical symptoms of FAP in optimal portfolios generated by using completely aligned alpha and risk models.
Additionally, we provide theoretical guidance to clarify the role of constraints in influencing FAP and illustrate how the Alpha Alignment Factor (AAF) methodology can handle misalignment resulting from constraints, analytical complexities notwithstanding.
Author: Anureet Saxena, PhD, CFA, Christopher Martin, CAIA, and Robert A. Stubbs, PhD