Alphas in disguise: A new approach to uncovering them

Four‐factor Carhart alphas of passive indices should be zero, but recent empirical evidence shows otherwise. We propose an optimization algorithm that makes small (fixed) adjustments to the time series of the market, size, value, and momentum factors, which ensures a zero alpha for any (single) self...

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Bibliographic Details
Published in:International journal of finance and economics 2017-07, Vol.22 (3), p.234-243
Main Authors: Chinthalapati, Venkata, Mateus, Cesario, Todorovic, Natasa
Format: Article
Language:English
Subjects:
Carhart alpha adjustment
Mutual funds
non‐zero benchmark alphas
optimization algorithm
Optimization algorithms
performance evaluation
Stock market indexes
Time series
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Summary:Four‐factor Carhart alphas of passive indices should be zero, but recent empirical evidence shows otherwise. We propose an optimization algorithm that makes small (fixed) adjustments to the time series of the market, size, value, and momentum factors, which ensures a zero alpha for any (single) self‐designated benchmark index of a mutual fund. Our “adjusted factors” can then be used to estimate a mutual fund's “adjusted alpha.” We test this methodology on a sample of 1,281 active and 102 tracker U.S. equity mutual funds (reporting S&P 500 index as their prospectus benchmark). Our time series adjustment of the Carhart 4 factors leads to an increase (decrease) in a fund's “adjusted alpha” in periods of fund‐benchmark underperformance (outperformance). On the whole, our “adjusted alphas” of both active and tracker funds are statistically significantly negative. This is particularly pronounced for tracker funds.
ISSN:1076-9307
1099-1158
DOI:10.1002/ijfe.1581