Tim Olson
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47 lines
2.8 KiB
Markdown
47 lines
2.8 KiB
Markdown
---
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description: "Rotates into sector ETFs with the highest Jensen's alpha estimated from a Fama-French factor regression, replacing raw cumulative return momentum with factor-adjusted alpha as the ranking signal."
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tags: [etfs, alpha, momentum, fama-french, rotation]
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---
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# Alpha Rotation
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**Section**: 4.2 | **Asset Class**: ETFs | **Type**: Momentum / Factor-Adjusted Rotation
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## Overview
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Alpha rotation is structurally the same as the sector momentum rotation strategy (Section 4.1), but replaces cumulative ETF returns `R_i^cum` with ETF alphas `alpha_i`. These alphas are the Jensen's alpha regression coefficients from a serial regression of each ETF's returns on the Fama-French factors, representing the ETF's return unexplained by common risk factors.
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## Construction / Signal
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Run a serial regression of ETF returns `R_i(t)` on the 3 Fama-French factors (MKT, SMB, HML):
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```
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R_i(t) = alpha_i + beta_{1,i} MKT(t) + beta_{2,i} SMB(t) + beta_{3,i} HML(t) + epsilon_i(t) (364)
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```
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The regression coefficient `alpha_i` (Jensen's alpha) corresponds to the intercept and measures the ETF's risk-adjusted excess return relative to the Fama-French model. This alpha replaces `R_i^cum` as the ranking criterion.
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ETFs are ranked by `alpha_i` (descending). Buy top-decile ETFs (highest alpha) and optionally short bottom-decile ETFs (lowest/most-negative alpha).
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## Entry / Exit Rules
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- **Entry**: At rebalance, estimate alpha for each ETF over the estimation period; rank and enter positions in top-decile (long) and optionally bottom-decile (short).
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- **Exit**: Hold for the standard holding period; rebalance at next scheduled interval.
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- **Estimation period**: Typically 1 year; returns `R_i(t)` are daily or weekly.
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## Key Parameters
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- **Factor model**: 3 Fama-French factors (MKT, SMB, HML); note alpha here is Jensen's alpha for ETF returns, not mutual fund alpha
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- **Estimation period**: Typically 1 year
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- **Return frequency for regression**: Daily or weekly `R_i(t)`
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- **Holding period**: Same as sector momentum rotation (1–3 months)
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- **Ranking criterion**: `alpha_i` (intercept of Fama-French regression)
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## Variations
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- **4-factor model**: Add Carhart momentum factor MOM(t) to regression for a 4-factor alpha
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- **R-squared augmentation**: Combine alpha ranking with R-squared selectivity measure (see Section 4.3)
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- **Long-only**: Buy only top-decile ETFs by alpha
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## Notes
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- Estimation period is typically 1 year with daily or weekly return data.
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- Jensen's alpha here is defined for ETF returns (not mutual fund returns as in Jensen, 1968).
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- Alpha rotation is analytically cleaner than raw momentum rotation as it removes systematic factor exposures from the ranking signal.
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- The MA filter and dual-momentum variations from Section 4.1.1 and 4.1.2 can also be applied here.
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- Can be combined with R-squared (Section 4.3) to further refine ETF selection.
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