Finding Alphas, 2nd Edition

13Alpha and Risk Factors

By Peng Wan

In this chapter, we will review the practice of seeking alphas from a historical perspective. We will examine a few well-studied alphas and observe that some evolve to become “hedge fund betas,” or risk factors.

Building on Markowitz's work (1952) on the expected returns and variance of returns of a portfolio, Treynor (1962), Sharpe (1964), Lintner (1965), and Mossin (1966) developed the capital asset pricing model (CAPM) in the 1960s. According to CAPM, a stock's expected return is the investor's reward for the stock's market risk:

Since its birth, CAPM has been challenged for its restrictive assumptions and inconsistency with empirical data. The arbitrage pricing theory (APT), developed chiefly by Ross (1976), does not require the stringent assumptions of CAPM. APT states that in a market with perfect competition, a stock's expected return is a linear function of its sensitivities to multiple unspecified factors:

CAPM and APT provided the theoretical foundation of stock return analysis and alpha evaluation. In practice, the factors in APT can be constructed as stock portfolios, and most of them can be constructed as both dollar-neutral and market-beta-neutral portfolios. Each of these beta-dollar-neutral factors can be evaluated as a potentially ...