Factor Misalignment And Portfolio Construction

Volume 14, Number 2, 2016
Jose Menchero

In recent years, there has been heightened interest among practitioners in the topic of factor misalignment; this term refers to the practice of employing mean-variance optimization to construct portfolios when the alpha signal is not contained within the set of risk model factors. In this paper, we employ a realistic simulation framework to study the efficiency of optimized portfolios under a variety of conditions. In particular, we study the case in which the alpha factor contains true systematic risk, and the case in which it does not. We also consider two risk models: one that contains the alpha factor, and the other that omits it.We find some evidence to support a modest increase in portfolio information ratio when the alpha factor is included in the risk model, provided two conditions hold: (1) the alpha factor must include true systematic risk, and (2) the factor correlations must be estimated with sufficient precision. If the alpha factor does not contain true factor risk, we find that including the alpha signal in the risk model is detrimental to portfolio information ratio. Finally, we conduct an empirical analysis of portfolio efficiency in the US stock market and find that the results are in excellent agreement with our simulations.