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Factor Models for Alpha Streams

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  • Zura Kakushadze

Abstract

We propose a framework for constructing factor models for alpha streams. Our motivation is threefold. 1) When the number of alphas is large, the sample covariance matrix is singular. 2) Its out-of-sample stability is challenging. 3) Optimization of investment allocation into alpha streams can be tractable for a factor model alpha covariance matrix. We discuss various risk factors for alphas such as: style risk factors; cluster risk factors based on alpha taxonomy; principal components; and also using the underlying tradables (stocks) as alpha risk factors, for which computing the factor loadings and factor covariance matrices does not involve any correlations with alphas, and their number is much larger than that of the relevant principal components. We draw insight from stock factor models, but also point out substantial differences.

Suggested Citation

  • Zura Kakushadze, 2014. "Factor Models for Alpha Streams," Papers 1406.3396, arXiv.org, revised Oct 2014.
  • Handle: RePEc:arx:papers:1406.3396
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    References listed on IDEAS

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    1. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    2. Blume, Marshall E & Friend, Irwin, 1973. "A New Look at the Capital Asset Pricing Model," Journal of Finance, American Finance Association, vol. 28(1), pages 19-33, March.
    3. Adrian, Tobias & Franzoni, Francesco, 2009. "Learning about beta: Time-varying factor loadings, expected returns, and the conditional CAPM," Journal of Empirical Finance, Elsevier, vol. 16(4), pages 537-556, September.
    4. Michael J. Cooper & Huseyin Gulen & Michael J. Schill, 2008. "Asset Growth and the Cross-Section of Stock Returns," Journal of Finance, American Finance Association, vol. 63(4), pages 1609-1651, August.
    5. Hall, Anthony D. & Hwang, Soosung & Satchell, Stephen E., 2002. "Using Bayesian variable selection methods to choose style factors in global stock return models," Journal of Banking & Finance, Elsevier, vol. 26(12), pages 2301-2325.
    6. Agarwal, Vikas & Naik, Narayan Y., 2000. "Multi-Period Performance Persistence Analysis of Hedge Funds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 35(03), pages 327-342, September.
    7. Fung, William & Hsieh, David A., 1999. "A primer on hedge funds," Journal of Empirical Finance, Elsevier, vol. 6(3), pages 309-331, September.
    8. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
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    Cited by:

    1. Zura Kakushadze, 2015. "Combining Alphas via Bounded Regression," Risks, MDPI, Open Access Journal, vol. 3(4), pages 1-17, November.
    2. repec:pal:assmgt:v:19:y:2018:i:1:d:10.1057_s41260-017-0059-2 is not listed on IDEAS
    3. Zura Kakushadze & Willie Yu, 2017. "Decoding Stock Market with Quant Alphas," Papers 1708.02984, arXiv.org.
    4. repec:pal:assmgt:v:18:y:2017:i:1:d:10.1057_s41260-016-0004-9 is not listed on IDEAS
    5. Zura Kakushadze & Willie Yu, 2016. "How to Combine a Billion Alphas," Papers 1603.05937, arXiv.org, revised Jun 2016.

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