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Alpha signal is the net forward-looking estimate of an asset's future potential relative to other securities in a coverage universe. It is input as the numerator for the Mean Variance Optimization (MVO). An active manager calculates an expected return, typically using CAPM and then subtracts that from the forecast return in order to arrive at an alpha signal.
As an example, if a stock's consensus expected return (from CAPM) is 7%, and the active manager's forecast return is 9%, then the alpha signal is 2%. This signal may further be standardized across all securities in the coverage universe.
For context, an active equity portfolio manager will find a risk-adjusted return expectation using a stock's systematic risk, or beta, and through CAPM arrive at a market-expected rate of return. From there, the active manager forms a differt opinion and exploits it through overweighting or underweighting the stock.
The term alpha can be applied to both stock forecasts here, and to past performance from a single-variable linear regression.
Guy: Pam refuses to accept that we need an
alpha signal on every stock weekly.
Eve: Fundamentalists and quants are like oil and water at times.
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True. That's a commonly-used method.
Yes and No. It depends on how portfolio weights are set. Two common options include systematic processes with portfolio optimization, or rules-based, like equal-weight.
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