# Combining Alphas via Bounded Regression

^{1}

^{2}

## Abstract

**:**

## 1. Introduction

## 2. Bounded Regression

#### 2.1. Notations

#### 2.2. Weighted Regression

#### 2.3. Bounds

#### 2.4. Running a Bounded Regression

#### 2.5. Application to Stock Portfolios

#### 2.5.1. Establishing Trades

#### 2.5.2. Rebalancing Trades

#### 2.5.3. Examples: Intraday Mean Reversion Alphas

**Table 1.**Simulation results for the 5 alphas via regression without bounds discussed in Section 2.5.3. ROC, return-on-capital; SR, Sharpe ratio; CPS, cents-per-share; BICS, Bloomberg Industry Classification System.

Alpha | ROC | SR | CPS |
---|---|---|---|

Regression: Intercept only | 33.59% | 5.59 | 1.38 |

Regression: BICS sectors | 39.28% | 7.05 | 1.61 |

Regression: BICS industries | 42.66% | 8.19 | 1.75 |

Regression: BICS sub-industries | 45.25% | 9.22 | 1.84 |

Regression: 4 style factors plus BICS sub-industries | 46.60% | 9.85 | 1.90 |

**Figure 1.**P&L graphs for the intraday alphas discussed in Section 2.5.3, with a summary in Table 2. Bottom-to-top-performing: (i) regression over intercept only; (ii) regression over BICS sectors; (iii) regression over BICS industries; (iv) regression over BICS sub-industries; and (v) regression over the four style factors, prc, mom, hlvand vol, of [60] plus BICS sub-industries. The investment level is $10 M long plus $10 M short.

**Table 2.**Simulation results for the 5 alphas via bounded regression discussed in Section 2.5.3.

Alpha | ROC | SR | CPS |
---|---|---|---|

Regression: Intercept only | 29.66% | 7.36 | 1.25 |

Regression: BICS sectors | 35.32% | 9.89 | 1.48 |

Regression: BICS industries | 39.25% | 12.00 | 1.65 |

Regression: BICS sub-industries | 42.23% | 14.13 | 1.75 |

Regression: 4 style factors plus BICS sub-industries | 43.70% | 15.54 | 1.82 |

## 3. Concluding Remarks

## Conflicts of Interest

## Appendix

## A. The R Code

`calc.bounded.lm()`, which runs the γ iteration loop and calls the function

`bounded.lm()`, which runs the ${J}^{\pm}$ iteration loop. The

`args()`of

`calc.bounded.lm()`are:

`ret`, which is the N-vector of alphas ${\alpha}_{i}$ (or, more generally, some other returns);

`load`, which is the $N\times K$ loadings matrix ${\Lambda}_{iA}$;

`weights`, which is the N-vector of the regression weights ${z}_{i}$;

`upper`, which is the N-vector of the upper bounds ${w}_{i}^{+}$;

`lower`, which is the N-vector of the lower bounds ${w}_{i}^{-}$; and

`prec`, which is the desired precision with which the output weights ${w}_{i}$, the N-vector of which

`calc.bounded.lm()`returns, must satisfy the normalization condition Equation (1). Internally,

`bounded.lm()`calls the function

`calc.bounds()`, which computes ${\widehat{w}}_{i}^{(s+1)}$ in Equation (24) at each iteration. The code is straightforwardly self-explanatory.

`Jp, Jm`in

`bounded.lm()`correspond to ${J}^{\pm}$. One subtlety is that, when restricting ${\Lambda}_{iA}$ to $\tilde{J}\subset J$, in the case of binary industry classification (e.g., when ${\Lambda}_{iA}$ corresponds to BICS sub-industries, which can be small), the so-restricted ${\Lambda}_{iA}$ may have null columns, which must be omitted, and the code below does just that. For non-binary cases, one may wish to augment the code to ensure that the matrix

`Q <- t(load[Jt, take]) %*% w.load[Jt, take]`is nonsingular (and, if it is, then remove the culprit columns in ${\Lambda}_{iA}$ or otherwise modify the latter); however, for non-binary ${\Lambda}_{iA}$ and generic regression weights, this should not occur, except for special, non-generic cases.

```
````calc.bounded.lm <- function(ret, load, weights, upper, lower, prec = 1e-5)`
`{`
`reg <- lm(ret ∼ -1 + load, weights = weights)`
`x <- weights * residuals(reg)`
`ret <- ret / sum(abs(x))`
`repeat{`
`x <- bounded.lm(ret, load, weights, upper, lower)`
`if(abs(sum(abs(x)) - 1) < prec)`
`break`
`ret <- ret / sum(abs(x))`
`}`
`return(x)`
`}`
`bounded.lm <- function(ret, load, weights, upper, lower, tol = 1e-6)`
`{`
`calc.bounds <- function(z, x)`
`{`
`q <- x - z`
`p <- rep(NA, length(x))`
`pp <- pmin(x, upper)`
`pm <- pmax(x, lower)`
`p[q > 0] <- pp[q > 0]`
`p[q < 0] <- pm[q < 0]`
`t <- (p - z)/q`
`t <- min(t, na.rm = T)`
`z <- z + t * q`
`return(z)`
`}`
`if(!is.matrix(load))`
`load <- matrix(load, length(load), 1)`
`n <- nrow(load)`
`k <- ncol(load)`
`ret <- matrix(ret, n, 1)`
`upper <- matrix(upper, n, 1)`
`lower <- matrix(lower, n, 1)`
`z <- diag(weights)`
`w.load <- z %*% load`
`w.ret <- z %*% ret`
`J <- rep(T, n)`
`Jp <- rep(F, n)`
`Jm <- rep(F, n)`
`z <- rep(0, n)`
`repeat{`
`Jt <- J & !Jp & !Jm`
`y <- t(w.load[Jt, ]) %*% ret[Jt, ]`
`if(sum(Jp) > 1)`
`y <- y + t(load[Jp, ]) %*% upper[Jp, ]`
`else if(sum(Jp) == 1)`
`y <- y + upper[Jp, ] * matrix(load[Jp, ], k, 1)`
`if(sum(Jm) > 1)`
`y <- y + t(load[Jm, ]) %*% lower[Jm, ]`
`else if(sum(Jm) == 1)`
`y <- y + lower[Jm, ] * matrix(load[Jm, ], k, 1)`
`if(k > 1)`
`take <- colSums(abs(load[Jt, ])) > 0`
`else`
`take <- T`
`Q <- t(load[Jt, take]) %*% w.load[Jt, take]`
`Q <- solve(Q)`
`v <- Q %*% y[take]`
`xJp <- Jp`
`xJm <- Jm`
`x <- w.ret - w.load[, take] %*% v`
`x[Jp, ] <- upper[Jp, ]`
`x[Jm, ] <- lower[Jm, ]`
`z <- calc.bounds(z, x)`
`Jp <- abs(z - upper) < tol`
`Jm <- abs(z - lower) < tol`
`if(all(Jp == xJp) & all(Jm == xJm))`
`break`
`}`
`return(z)`
`}`

## B. Disclaimers

^{®}Solutions LLC and is provided herein with the express permission of Quantigic

^{®}Solutions LLC. The copyright owner retains all rights, title and interest in and to its copyrighted source code included in Appendix A hereof and any and all copyrights therefor.

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^{1}Here “alpha”, following the common trader lingo, generally means any reasonable “expected return” that one may wish to trade on and is not necessarily the same as the “academic” alpha. In practice, often, the detailed information about how alphas are constructed may not be available, e.g., the only data available could be the position data, so “alpha” then is a set of instructions to achieve certain stock holdings by some times ${t}_{1},{t}_{2},\cdots $^{2}For a partial list of hedge fund literature, see, e.g., [4,5,6,7,8,9,10,11,12,13,14,15,16,17,18,19,20,21,22,23] and the references therein. For a partial list of portfolio optimization and related literature, see, e.g., [24,25,26,27,28,29,30,31,32,33,34,35,36,37,38,39,40,41,42,43,44,45,46,47,48,49,50,51,52,53,54,55,56,57,58] and the references therein.^{3}One approach to rectify this is to add a turnover-based factor to the loadings matrix [1].^{4}For a recent discussion, see [59].^{5}Actually, this assumes that there are no N/Asin any of the alpha time series. If some or all alpha time series contain N/As in a non-uniform manner and the correlation matrix is computed by omitting such pair-wise N/As, then the resulting correlation matrix may have negative eigenvalues that are not zeros distorted by computational rounding.^{6}Here, the turnover (over a given period, e.g., daily turnover) is defined as the ratio ${\tau}_{i}\equiv {D}_{i}/{I}_{i}$ of total dollars ${D}_{i}$ (long plus short) traded by the alpha labeled by i over the corresponding total dollar holdings ${I}_{i}$ (long plus short).^{7}By capacity ${I}_{i}^{*}$ for a given alpha, we mean the value of the investment level ${I}_{i}$ for which the P&L ${P}_{i}\left({I}_{i}\right)$ is maximized (considering nonlinear effects of impact).^{8}Since the regression we consider here is weighted with the regression weights ${z}_{i}=1/{C}_{ii}$, this already controls exposure to alpha volatility, so imposing bounds based on volatility would make a difference only if one wishes to further suppress volatile alphas.^{9}The regression limit of optimization essentially amounts to the limit ${\xi}_{i}^{2}\equiv \eta \phantom{\rule{3.33333pt}{0ex}}{\tilde{\xi}}_{i}^{2}$, $\eta \to 0$, ${\tilde{\xi}}_{i}^{2}=fixed$, where ${\xi}_{i}$ is the specific (idiosyncratic) risk in the factor model with the factor loadings matrix identified with the regression loadings matrix ${\Lambda}_{iA}$ (and the $K\times K$ factor covariance matrix becomes immaterial in the regression limit); see [2] for details.^{10}This is the case if the columns of ${\Lambda}_{iA}$ are comprised of the first K principal components of SCM ${C}_{ij}$ corresponding to its positive eigenvalues. However, as mentioned above, here, we keep the loadings matrix general.^{11}Various generalizations are possible, some more straightforward than others.

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## Share and Cite

**MDPI and ACS Style**

Kakushadze, Z. Combining Alphas via Bounded Regression. *Risks* **2015**, *3*, 474-490.
https://doi.org/10.3390/risks3040474

**AMA Style**

Kakushadze Z. Combining Alphas via Bounded Regression. *Risks*. 2015; 3(4):474-490.
https://doi.org/10.3390/risks3040474

**Chicago/Turabian Style**

Kakushadze, Zura. 2015. "Combining Alphas via Bounded Regression" *Risks* 3, no. 4: 474-490.
https://doi.org/10.3390/risks3040474