Alpha and the low risk anomaly Flashcards
(16 cards)
What is the low risk anomaly?
Low risk anomaly suggests that firms with lower betas and lower volatility have higher returns over time.
What is alpha?
It is a statement of average performance in excess of a benchmark.
What is active return?
Active return is the difference between the return of an asset and the return of the asset’s benchmark.
If the benchmark is passive, then any additional return that the investor achieves is from doing something different from the benchmark.
Alpha= average excess return for T observations.
What is tracking error?
Standard deviations of excess returns. It measures the dispersion of the investor’s returns relative to the benchmark.
Larger tracking errors indicate that the manager has more freedom in decision making.
What is information ratio?
Alpha/ Tracking Error
Active investment choices can be ranked based on their IR scores.
What is Sharpe ratio?
Total excess return/ total risk
Appropriate when the risk free rate is the appropriate benchmark
What are the qualities of an appropriate benchmark?
- Well defined (hosted by an independent index provider)
- Tradeable (must have a basket of tradeable securities)
- Replicable
- Adjusted for risk
Fundamental law of active management
IR = IC * sqrt (BR)
IC» Information coefficient
BR»Breadth»no. of investments deployed
Information coefficient
Correlation between an investment’s predicted and actual value.
A lower IC means lower quality predictions
What is the central tradeoff in active management?
Investors need to make high quality predictions, or do a lot of trading activity.
However, this Grinold’s framework ignores downside risk and makes the critical assumption that all forecasts are independent of one another.
Why are some mutual funds close to new investors and turn away new assets once they reach a set size?
To restrict BR
What is style analysis?
it is a form of factor benchmarking where factor exposures evolve over time.
Style analysis also adjusts for the fact that factor loadings (betas) change over time.
What is the issue with alpha measurement for non linear strategies
Alpha is computed using regression, which operates in a linear framework. However, there are non linear strategies, that can make it appear that alpha exists when it doesn’t.
One reason is because, the distribution of returns is not a normal distribution, and also some non linear strategies exhibit negative skewness, which is not factored into the calculation of alpha.
What is volatility anomaly?
As SD increased, both the average returns and Sharpe ratios decreased
What is beta anomaly?
Higher beta have lower sharpe ratios (risk adjusted performance) because higher betas are paired with high volatility as measured by SD
What are the explanations of risk anomaly?
Some say data mining, some say leverage constrained investors (who look for high beta stocks and push them up by buying them), also constraints of institutional managers, and sometimes, investors simply have preference for high volatility and high beta stocks
