How do I build an alpha budget for an enhanced indexing mandate?

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AcadiFi · Accepted Answer

Alpha budgeting for enhanced indexing translates a tracking error (TE) budget into position-level active weights. Start with the core identity: IR = IC × sqrt(BR), where IC is information coefficient and BR is breadth (independent bets per year). With TE budget of 150 bps on a $3.2B mandate, your target IR might be 0.5, giving expected alpha of 75 bps. Allocate TE across strategies. Suppose you have four signals: value (IC 0.06), quality (IC 0.05), earnings revisions (IC 0.08), and low volatility (IC 0.04). Breadth is the number of independent applications; with 1000 stocks and quarterly rebalance, breadth per signal is roughly 200-400 after accounting for correlations. Optimal TE weights per strategy are proportional to IC squared divided by correlation-adjusted variance. Higher-IC signals earn more TE. For earnings revisions (highest IC), allocate 50 bps TE; value 40 bps; quality 35 bps; low vol 25 bps. Combined TE from correlated sources is below the sum. Position-level constraints matter: max active weight per stock 1.5%, max sector tilt 3%, turnover cap 120% annually, and beta tolerance 0.95-1.05. Implement via a mean-variance optimizer with the covariance matrix from a risk model (Barra, Axioma) using TE as the risk constraint. Monitor realized TE weekly; if realized exceeds 180 bps, dial back. Review alpha attribution quarterly. An enhanced indexer achieving 40-70 bps net alpha with IR 0.4-0.6 is competitive.

How do I build an alpha budget for an enhanced indexing mandate?

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