Title: Understanding alpha decay
Authors: Julien Penasse - University of Luxembourg (Luxembourg) [presenting]
Abstract: The relationship between realized anomaly returns and expected risk-adusted anomaly returns (alpha) is clarified. When the alpha of an anomaly decays, for example after the anomaly has been discovered and traded on, the portfolio's market value increases leading to outsized positive realized returns. That is, the average of (recent) past realized returns leads to an overestimation of expected returns (alpha) going forward. We show that ignoring this negative correlation between expected returns and realized returns can meaningfully affect statistical inference in the anomalies literature and we provide a simple formula that corrects for this effect.