MANAGING THE VOLATILITY OF ALPHA MODELS

Tony Elavia and Migene Kim

After posting good performance for over two decades, quantitative equity investment managers have recently produced weak returns. We develop a measure of risk and show how changes in risk provide a common framework to explain factor returns and past underperformance. We find that the quantitative stock ranking models based upon factor weights that vary with their conditional (on risk) forecasted returns are superior to traditional models with fixed weights based upon unconditional historical averages. The suggested improvements to investment processes rely upon objective and well-defined relationships between factor returns and risk.