Daily Academic Alpha: Dude, Where’s my Alpha?

/Daily Academic Alpha: Dude, Where’s my Alpha?

Daily Academic Alpha: Dude, Where’s my Alpha?

By | 2017-08-18T17:07:39+00:00 May 8th, 2015|Uncategorized|Comments Off on Daily Academic Alpha: Dude, Where’s my Alpha?

Seeking Alpha? It’s a Bad Guideline for Portfolio Optimization

Alpha is the most popular measure for evaluating the performance of both individual assets and funds. The alpha of an asset with respect to a given benchmark portfolio measures the change in the portfolio’s Sharpe ratio driven by a marginal increase in the asset’s portfolio weight. Thus, alpha indicates which assets should be marginally over/underweighted relative to the benchmark weights, and by how much. This study shows that alpha is actually a bad guideline for portfolio optimization. The reason is that alpha only measures the effects of infinitesimal changes in the portfolio weights. For small but finite changes, which are those relevant to investors, the optimal weight adjustments are almost unrelated to the alphas. In fact, in many cases the optimal adjustment is in the opposite direction of alpha – it may be optimal to reduce the weight of an asset with a positive alpha, and vice versa. Rather than employing alphas as a guideline, one can do much better by direct optimization with the desired constraint on the distance from the benchmark.

When Fund Flows Take the Fun (Alpha) Away

We provide new evidence for diseconomies of scale at the mutual fund level. Building on Berk and Green (2004) and allowing for gradual adjustment to equilibrium, we show that (quarterly) changes in fund performance are strongly negatively related to lagged predicted fund flows. We find that alphas would be more cross-sectionally dispersed and more persistent without the damping effect of flows. Thus, flows are an important factor behind the lack of predictability in mutual fund performance. This flow mechanism is strongest for smaller and more active funds with higher expense ratios, suggesting that it is related to the stock illiquidity and costly search for investment opportunities.

  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
  • Join thousands of other readers and subscribe to our blog.
  • This site provides NO information on our value ETFs or our momentum ETFs. Please refer to this site.

Print Friendly, PDF & Email

About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.