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

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...