LO 66.3: Describe neutralization and methods for refining alphas to be neutral.

LO 66.3: Describe neutralization and methods for refining alphas to be neutral.
Neutralization is the process of removing biases and undesirable bets from alpha. There are several types of neutralization: benchmark, cash, and risk-factor. In all cases, the type of neutralization and the strategy for the process should be specified before the process begins.
Benchmark neutralization eliminates any difference between the benchmark beta and the beta of the active portfolio. In this case we say the portfolio alpha of the active portfolio is zero. Consider an active portfolio that has a beta of 1.1 when the benchmark portfolio has a beta of 1. This represents an active bet on market (and benchmark portfolio) returns. When market returns are high, the active portfolio will outperform the benchmark portfolio;
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Topic 66 Cross Reference to GARP Assigned Reading – Grinold and Kahn, Chapter 14
when returns are low (less than the risk-free rate) the active portfolio will underperform the benchmark portfolio. The alphas can be adjusted so that the active portfolio beta is the same as the benchmark portfolio beta, unless the manager intends to make an active bet by increasing or decreasing the active portfolio beta relative to that of the benchmark. Matching the beta of the active portfolio to the beta of the benchmark portfolio is referred to as benchmark neutralization. Note that this neutralization is equivalent to adding a constraint on portfolio beta in a mean-variance optimization.
Computing modified benchmark-neutral alpha involves subtracting (benchmark alpha x active position beta) from the alpha of the active position. For example, assume benchmark alpha is equal to 0.013%. If an active position has an alpha of 0.3% and a beta of 1.2, the modified benchmark-neutral alpha will equal: 0.3% (0.013% x 1.2) = 0.48%.
In the explanation, we used a single risk factor, market risk. There may be other risk factors, such as those from a multi-factor returns generating model, that lead to unintended risk exposures relative to the benchmark. For example, consider the risk factor small cap returns minus large cap returns. The alpha inputs may produce an active portfolio with a greater sensitivity to this risk factor if the portfolios weight on small-cap firms is larger than that of the benchmark portfolio. Again, if this is unintended, alphas can be adjusted so that the beta of the active portfolio with respect to this risk factor matches that of the benchmark portfolio.
The active portfolio may also be neutralized with respect to industry risk factors, by matching the portfolio weights of each industry to those of the benchmark portfolio. In this case, subtracting the average alpha for an industry from the alphas of each firm within that industry will result in an active portfolio that is neutral relative to the benchmark with respect to industry risk factors. In each of our examples, neutralization reduces active risk by matching the factor risks of the active portfolio to those of the benchmark portfolio.
An active portfolio can also be made cash neutral, by adjusting the alphas so that the portfolio has no active cash position. Its possible to make the alpha values both cash- and benchmark-neutral.
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