Abstract
The practical issues that arise due to the interaction between three principal players in any quantitative strategy, namely, the alpha model, the risk model and the constraints are collectively referred to as Factor Alignment Problems (FAP). While the role of misaligned alpha factors in causing FAP is relatively easy to understand, incorporating the impact of constraints entails considerable analytical complexity that most consultants and researchers find difficult to fathom. We argue that simply aligning alpha and risk factors is insufficient in handling FAP. We demonstrate that the typical symptoms of FAP are present in optimal portfolios generated by using completely aligned alpha and risk models. In addition, we provide theoretical guidance to clarify the role of constraints in influencing FAP and illustrate how the Alpha Alignment Factor methodology can handle misalignment resulting from constraints, analytical complexities notwithstanding.
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