Alpha Signals, Smart Betas, and Factor Model Alignment

The authors compare errors of omission and of commission of factor risks in portfolios.  An error of omission happens when an investor thinks excess return is caused by alpha, when in fact it is due to an unperceived factor risk; an error of commission happens when an investor thinks excess return is caused by excess factor risk, when in fact it is due to alpha.  The authors find that if an investor commits an error of omission, the losses can be twice as large as those incurred by committing an error of commission.

If the alpha is true alpha, the investor should not adjust portfolios for factor risks; however, it is prudent to balance the risks of omission and of commissions by normalizing alphas and betas accordingly.  This can be done by tempering alphas for the potential of alpha noise. 

MARSH, T., & PFLEIDERER, P. (2016). Alpha Signals, Smart Betas, and Factor Model Alignment. Journal Of Portfolio Management, 42(5), 51-66.