Finding Alphas, 2nd Edition

14Risk and Drawdowns

By Hammad Khan and and Rebecca Lehman

Finding alphas is all about returns over risk. Everyone knows what returns are, but what is risk? Researchers often conflate different types of risk, which require different forms of measurement and control. In truth, the set of potential types of risk is unbounded. At the far end are Knightian uncertainty and black swans – risks that are a priori unknowable but can be rationalized and overfit after the fact. The only constructive thing that can be said about these risks is that they exist and any attempt to rationalize them after they have occurred is an exercise in futility. Overly complex risk models may contain epicycles upon epicycles that are intended to mitigate the last black swan event but will do nothing for the next one except make the models more brittle. Slightly closer to home are asset-specific and operational risks, which the practitioner can and should take into account but are not amenable to a broad treatment. This chapter will focus on the near end of the risk spectrum – the most well defined and commonly considered types, which can be broadly classified as extrinsic and intrinsic risks.

Many alphas are exposed to extrinsic, or external, factors that are not related to their source of returns, such as the behavior of a given industry or the market as a whole. Other risk factors include alpha strategies that have been largely arbitraged away but are still highly traded and prone to momentum periods ...