The alpha alignment factor: a solution to the underestimation of risk for optimized active portfolios

A common criticism of risk models is that they have a tendency to underestimate the risk associated with optimized portfolios. Quantitative portfolio managers have historically used a variety of ad hoc techniques to overcome this issue in their investment processes. In this paper, we construct a theory explaining why risk models underestimate the risk of optimized portfolios. We show that the problem does not necessarily lie solely with the risk...