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Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

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11 Alpha and Risk Factors

By Peng Wan

In this chapter, we will review alpha hunting practice from a historical perspective. We will go through a few well-studied market “anomalies” and make the point that some alphas evolve to become “hedge fund betas” or risk factors.

Building on Markowitz’s earlier work (1952) on a portfolio’s “expected returns and variance of returns,” 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 reward for its bearing of market risk:

Expected return = Risk-free rate + Stock’s market beta * Market risk premium

For the purpose of alpha evaluation, we need to filter out this market beta component and focus on what is left. In practice, when we express an alpha as a vector of stock weights, we usually target dollar and beta neutrality.

Since its birth, CAPM has been challenged due to its overly restrictive assumptions and its contradiction to empirical data. On the other hand, its methodology of dissecting stock returns into common risk factors and idiosyncratic risk is widely adopted in both academic research and practice.

In their paper, Fama and French (1992) added two risk premiums, size and value, to explain stock returns. Size effect says smaller stocks tend to outperform larger stocks. Value effect says stocks with higher book-to-market equity carry a positive risk premium in their return. The alternative measurements ...

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