Inside the Black Box: The Simple Truth About Quantitative Trading

Chapter 3. Alpha Models: How Quants Make Money

Prediction is very difficult, especially about the future.

—Niels Bohr

Having surveyed it from the outside, we begin our journey through the black box by understanding the heart of the actual trading systems that quants use. This first piece of a quant trading system is its alpha model, which is the part of the model that is looking to make money and is where much of the research process is focused. Alpha, the spelled-out version of the Greek letter α, generally is used as a way to quantify the skill of an investor or the return she delivers independently of the moves in the broader market. By conventional definition, alpha is the portion of the investor's return not due to the market benchmark, or, in other words, the value added (or lost) solely because of the manager. For instance, if a manager is up 12 percent and her respective benchmark is up only 10 percent, a quick back-of-the-envelope analysis would show that her alpha, or value added, is +2 percent. This value added could be a result of luck, or it could be because of skill. Alpha models are therefore the quant's approach to adding skill to the investment process in order to make profits. For example, a trend-following trader's ability to identify trends that will persist into the future represents one type of skill that can generate profits.

What is common to all pursuits of alpha is that they are in essence designed to time the selection and/or sizing of portfolio holdings ...