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Alpha is regularly bandied about by traders and other investment professionals but what does it actually mean? Generally, it represents the excess return earned on an investment or trade above a benchmark return when adjusted for risk. The key point to emphasise here is the risk adjustment. Investors often believe that alpha is generated when you beat the benchmark but if you have done this through a riskier investment strategy then you have not necessarily generated positive alpha. So, if you are beating the market on a risk-adjusted basis, can you do this consistently?
Modern Portfolio Theory underpins the discussion on alpha
Modern Portfolio Theory uses five statistical measurements in assisting investors in evaluating the risk return parameters of an investment, namely:
• Alpha – excess return earned on an investment relative to a benchmark return
• Beta – measures an investment’s volatility or systematic risk compared to the overall market
• Sharpe Ratio – divides a portfolio’s excess returns by a measure of its volatility to assess risk adjusted performance
• Standard Deviation – measures the dispersion of a dataset relative to its mean and its calculated as the square root of its variance. This is often used as a measure of the relative riskiness of an asset/investment
• R-squared – measure that indicates how much of the variation of a dependent variable is explained by an independent variable in a regression model. In investing this is interpreted as the percentage of a fund’s or security’s price movements that can be explained by movements in a benchmark index.
Alpha has become a key discussion point for investors especially with the growth in the use of beta indexes and passive exchange traded funds. A key selling point for active portfolio managers is that they can generate alpha through their methods (analysis/stock picking/research) that beat the returns from passive investing indexes and ETFs thereby justifying their higher fees. If active managers cannot generate alpha then an investor is better placed investing in an index with lower fees attached to it.
Portfolio Managers and Consistent Alpha
Efficient Market Theory suggests that it is not possible to consistently generate alpha as the prices on exchanges reflect all available information so there is no asymmetric information that can be garnered by an investor to get an edge. This theory states that the only way to get higher returns is to make riskier investments. While it is true that many indexes have outperformed some active managers consistently, there have also been a number of investors, like Warren Buffet to use a famous example, who have regularly outperformed the market consistently for many years. Primarily, the Efficient Market Theory assumes that all investors are rational decision-makers who use all new information to update their viewpoint and make optimal choices. Many would argue though, that the rationality assumption is flawed, and there is empirical evidence that investors are prone to irrational choices, particularly in extreme market situations of rapidly falling or rising prices.
Active portfolio managers use asymmetric information to try and generate alpha. Asymmetric information in financial markets refers to situations where either the buyer or seller has more information on the past, present, or future performance of an investment. One source of asymmetric information is insider information when material non-public information gives an investor an edge, but this is illegal in Nigeria and major financial markets. Some portfolio managers use research and analysis to identify undervalued or overvalued securities through the analysis of financial statements, industry trends etc. There is no limit to the nature of analysis that can be used, firms have been known for example to acquire satellite imagery of a target company’s factory loading yard to estimate factory output/sales from analysing how full the loading dock is with trucks before the company announces in its quarterly review.
Hedge funds and alternative investment managers have specialised in generating alpha in diversified portfolios with diversification intended to eliminate unsystematic risk or risk that is associated with a single industry or equity. They also use investments in private markets to generate better risk adjusted returns and increase investor portfolio diversification by combining higher returns, compared to public markets, with lower downside risk by utilising leverage, derivatives, shorting and diversification strategies that their mutual fund colleagues could not. There had been renewed interest in private markets as returns in public markets seemed to plateau, however public markets made a strong rebound when Central Banks globally intervened in the markets through quantitative easing which elevated asset prices. Investors are still looking at private markets to generate alpha as it is felt there is a better probability of that happening there compared to the more commoditised public markets.
Conclusion
Active portfolio managers utilise a number of strategies to try to generate consistent alpha, with some managers being more successful in this than others. Alpha has to be assessed within the prism of Modern Portfolio Theory as it evaluates risk return parameters. While Efficient Market Theory does have its merits, a strong case can be made against it using empirical evidence on investors lack of rational behaviour in some instances. Private markets/alternative investments have become more popular as a source of alpha in recent years and new products are making this once niche product for institutional investors and UHNIs only into an asset class that more investors can have access to.
Some have argued that the real key to outperformance is building a research process that is analytical, not informational, designed to filter information more effectively, rather than trying to forecast more precisely especially as technological and regulatory changes in the investment industry has commoditised information and levelled the playing field. This argument hinges on the premise that investors face a distribution of probabilities not possibilities (put forward in an article by Boston Partners). If you believe alpha is episodic then you should focus mainly on passive beta indexes and ETFs but by doing so you shut yourself out of any possibility of outperformance. However, it is possible to generate alpha and some managers have shown they can do this consistently and such managers should be the focus for investors. In doing so though, it is worth noting that as in most things, the best path is one of moderation which in this case would be diversification, construct an investment portfolio that combines both active and passive investment products.
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