Rethinking Valuation and Pricing Models

24

Active Portfolio Construction When Risk and Alpha Factors are Misaligned

Ralph Karels and Michael Sun

MSCI Consultants

Chapter Outline

24.1 Introduction

24.2 Framework for Active Portfolio Construction

24.3 Misalignment of Risk and Alpha Models

24.4 Portfolio Optimization with Alpha Decomposition

24.5 Mitigation for Alpha and Risk Factor Misalignment

24.6 Case Studies

24.7 Conclusion

References

24.1 Introduction

When looking at active portfolio optimization, there are three main ingredients: The portfolio manager’s return forecasts (alphas), a portfolio risk forecast and a risk aversion parameter.

In an ideal world, one factor model should account for both risk and return forecasts. In practice, however, portfolio managers use different models ...