For both quantitative and fundamental managers, alpha calibration is a critical part of the optimal portfolio construction process – but are you doing it right? Most optimization processes include an objective function with one or more terms. When multiple terms are included, managers often mix and match the scaling of the terms which is asking the optimizer to compare apples to oranges and leads to less relevant or suboptimal allocations.
In this paper, we review the different types of alphas generally used by portfolio managers and discuss potential consequences of not calibrating their alphas. We provide an overview of the calibration process with its intuition. In particular, portfolio managers need to take into account the current volatility environment and their limited forecasting ability in order to achieve properly calibrated alpha signals.