Using Alpha To Generate Alpha

We test whether the alpha of an investment relative to one’s existing portfolio can be used to improve out-of-sample performance (Sharpe ratio; Four-factor alpha). For the period 20002014, we confirm this for the Vanguard S&P 500 Index Fund and the Growth and Small Index Fund, which we extend by adding various Exchange Traded Funds. If one considers that our baseline funds may be proxies of the market portfolio, our results indirectly demonstrate that prices do not adjust (fast enough) to make those proxies mean-variance optimal, and hence, for the Capital Asset Pricing Model (CAPM) to emerge. Our findings also provide a foundation for recent studies that claim to be able to extract, from asset flows, the portfolio that investors use as benchmark. ∗Bossaerts and Yang are from Davide Eccles School of Business, University of Utah. This draft is preliminary. Comments are welcome.