Risk and Reward: A Quant Tragedy
Through careful research, you have assembled a collection of alphas that are correlated with future asset returns.
There's some conventional stuff (momentum, ST reversal, valuation, quality, short interest etc)...
1/7
Through careful research, you have assembled a collection of alphas that are correlated with future asset returns.
There's some conventional stuff (momentum, ST reversal, valuation, quality, short interest etc)...
1/7
There's some totally unique stuff (you think)...
And there's some stuff you're still clinging onto because you don't want to admit you wasted all that time and money on alternative data.
You take these alphas and you combine them into an expected return for each asset.
2/7
And there's some stuff you're still clinging onto because you don't want to admit you wasted all that time and money on alternative data.
You take these alphas and you combine them into an expected return for each asset.
2/7
You run some simple sense checks. Each period you sort the assets by expected return, long the top and short the bottom.
It looks good. You are encouraged.
But you wouldn't trade it like that.
Some assets are more volatile than others, many are driven by similar risks
3/7
It looks good. You are encouraged.
But you wouldn't trade it like that.
Some assets are more volatile than others, many are driven by similar risks
3/7
You want to minimize your exposure to most risk sources.
And you don't want the same basic-bitch return drivers like everyone else. Please. You could have ditched your research team and cribbed the Moskowitz papers for that.
You want that sweet unique uncorrelated alpha.
4/7
And you don't want the same basic-bitch return drivers like everyone else. Please. You could have ditched your research team and cribbed the Moskowitz papers for that.
You want that sweet unique uncorrelated alpha.
4/7
So you identify risk factors, either economically or statistically.
You create a covariance matrix of these risk factors using EWMA probably.
You fit a model to explain each asset's returns in terms of these risk factors.
5/7
You create a covariance matrix of these risk factors using EWMA probably.
You fit a model to explain each asset's returns in terms of these risk factors.
5/7
Now optimizer go brrr...
You maximize expected risk-adjusted returns whilst keeping your exposure to those risks and conventional factors close to 0.
You look at the results.
6/7
You maximize expected risk-adjusted returns whilst keeping your exposure to those risks and conventional factors close to 0.
You look at the results.
6/7
Your portfolio is market neutral.
It is neutral to all your identified risk factors.
It is also, you note, perfectly alpha neutral too.
7/7 Fin.
It is neutral to all your identified risk factors.
It is also, you note, perfectly alpha neutral too.
7/7 Fin.
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