Alpha is the quest of our industry. The managers that consistently deliver Alpha have the greatest odds of winning new assets, and crossing into the AUM threshold of the big brands. Winning new assets is what makes marketers giddy. By creating this as a post, and not an extensive white paper, we will briefly address four areas where Alpha is important to marketers.
Defining Alpha
To simplify, we are using a basic equity example. Every passive benchmark is a zero sum game. It is the performance of a set piece of the market, such as the S&P 500. Its performance is its own. Comparisons, therefore are clear. If a manager is beating the S&P 500 (creating and delivering alpha), then by definition, another manager has underperformed the S&P by exactly the same amount, delivering negative alpha. Combining this positive and negative alpha is the simple arithmetic of a zero sum game. The balance of the managers’ overall performance always equals the performance of the S&P 500. The manager delivering more, in its simplest description is delivering Alpha. The term has evolved further to be a demonstration of portfolio management skills. I have outperformed the market by over and underweighting sectors and industries. Is that skill, and therefore alpha? Yes, in its purest form. However, today alpha has layers. In equities, beating the market based solely upon the selection of individual securities is regarded by many institutions and media as the highest form of skill, and alpha delivery.
Why so many situations are mistakenly called Alpha
Having a portfolio of high beta stocks in an up market delivers outperformance. Is that in of itself Alpha? The answer is no. This type of strategy is viewed as elementary, and high risk. It is frequently viewed as fool’s gold, because it is not sustainable. If risk assets are in favor, it is not considered skillful to select the riskiest assets. It is an example of over performance, not outperformance, because in a down market this strategy will sink proportionally. Alpha, if created by skill, is repeatable and scalable. It delivers in more than one market condition.
Benchmark selection
For marketers, benchmarks are a double-edged sword. Optimally, funds should select ones that are familiar, fair, and appropriate to their target investors. The key is understanding that you will live with your benchmark for years, if not for eternity. For all those managers boasting low correlation to equities for instance, stop using the S&P 500 as your benchmark. It is a great (or should be) comparative tool in down years, and can be tragic in bull runs. One wants a benchmark that is enduring in all market conditions. It is how Alpha should be measured.
How to resist headlining your marketing with Alpha
Institutional quality marketing covers the five Ps (philosophy, process, people, product and performance). Showing what you do is sustainable, stable and scalable is the key to winning large allocations. Beating your appropriately selected benchmark in one year is worthy of being presented as a manifestation of your superior investment process. Repeating two years of Alpha is even more admirable and worthy of larger crowing. But be clear. There will be years of negative Alpha (unless your name is Soros, Cohen or Simons). As anyone who has won assets rapidly knows; those that live by performance…