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Article

Improving the Investment Process with a Custom Risk Model: A Case Study with the GLER Model

Kartik Sivaramakrishnan and Robert A. Stubbs
The Journal of Investing Winter 2013, 22 (4) 129-147; DOI: https://doi.org/10.3905/joi.2013.22.4.129
Kartik Sivaramakrishnan
is a senior research associate at Axioma, Inc., in Atlanta, GA.
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  • For correspondence: kksivara@axioma.com
Robert A. Stubbs
is vice president in research at Axioma Inc., in Atlanta, GA.
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  • For correspondence: rstubbs@axioma.com
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Abstract

The three ingredients in a mean–variance optimization model are the expected returns, the risk model, and constraints representing the portfolio manager’s mandates. Misalignment between the alpha vector and the risk model occurs when the alpha vector is not completely spanned by the factors in the risk model. It results in the optimizer taking large exposures on factors that have systematic risk but are missing from the risk model. With constraints, misalignment arises between the implied alpha and the risk model, resulting in portfolios that suffer from risk underestimation, undesired exposures to factors with hidden systematic risk, a consistent failure of the portfolio manager to achieve ex ante performance targets, and an intrinsic inability to transform superior alphas into outperforming portfolios. The authors use the global expected return (GLER) study to highlight the important role of custom risk models in addressing the misalignment between the implied alpha and the risk model. More specifically, they show that custom risk models 1) alleviate the risk-underestimation problem; 2) represent the alpha signal in the portfolio in an optimal risk-adjusted fashion, thereby delivering portfolios with high information ratios; and 3) generate a intuitive and useful ex post performance attribution analysis of the portfolio.

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The Journal of Investing: 22 (4)
The Journal of Investing
Vol. 22, Issue 4
Winter 2013
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Improving the Investment Process with a Custom Risk Model: A Case Study with the GLER Model
Kartik Sivaramakrishnan, Robert A. Stubbs
The Journal of Investing Nov 2013, 22 (4) 129-147; DOI: 10.3905/joi.2013.22.4.129

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Improving the Investment Process with a Custom Risk Model: A Case Study with the GLER Model
Kartik Sivaramakrishnan, Robert A. Stubbs
The Journal of Investing Nov 2013, 22 (4) 129-147; DOI: 10.3905/joi.2013.22.4.129
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  • Article
    • Abstract
    • THE GLER MODEL
    • CUSTOM RISK MODEL
    • GENERATING AN ALPHA FROM COMPOSITE GLER ATTRIBUTES
    • ILLUSTRATIVE EXAMPLE
    • CONCLUSIONS
    • ENDNOTES
    • REFERENCES
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