Understanding the power of alpha

Matt Scales, CFA, Head of Product Development and Strategy | January 27, 2014

  • Sources of return – such as quality alpha – that are not structurally tied to the direction of markets can be a valuable tool for diversifying portfolios
  • Market betas have a positive expected return but can be subject to long periods of poor performance
  • Finding sources of return that do not rely on markets going up to make money is not easy, but it is worth the effort

The term “alpha” (which until recently was relatively unknown) has become part of the mainstream investment lexicon. Alpha is the result of active management and is intended to generate positive returns above a benchmark that is not structurally tied to the direction of markets. Alpha can exist on its own, but it is more often packaged with the return of a particular market, or “beta,” a passive source of return. Alpha and beta — or active and passive — are the two primary sources of investment risk and return, and typically two sides of a philosophical debate.

Most investors have exposure to both alpha and beta, though typically more exposure to beta. Market betas are well known, easier to access and generally inexpensive. Structurally, they have a positive expected return but can be frustratingly inconsistent and marred by long periods of poor performance. One need not look very far to find examples of market betas that provided investors nothing over 15-year periods, 20-year periods or longer. While diversifying beta is an important step towards reducing dependency on any single market going up, this can only take us so far. If investors see this market dependency as a risk, the question then becomes, “How can I further diversify my portfolio?” This is where alpha can be especially valuable.

Alphas have very different characteristics. On average, alpha is a zero-sum game, though there are clearly those who generate it and those that do not. True alphas come from individual manager insights that are not structurally tied to the direction of markets (i.e., they do not require markets to go up to make money). This ability to generate positive, independent alpha allows for even greater potential diversification in a way that is difficult to achieve through beta.

Exhibit A shows the cumulative net of fee return for a top performing active U.S. equity manager over the last 10 years. Exhibit B isolates that same manager’s cumulative alpha (blue line) and then the net of fee performance of a leading passive option that replicates the Russell 1000 Index (yellow line), the same benchmark used by the active manager. The shaded red area ranges from October 2007 through February 2009, or the peak-to-trough in equities during the Financial Crisis.

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Source: Columbia Management Investment Advisers, LLC, November 2013. Past performance does not guarantee future results.

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Source: Columbia Management Investment Advisers, LLC, November 2013. Past performance does not guarantee future results. It is not possible to invest directly in an index. The Russell 1000 Index tracks the performance of 1000 of the largest U.S. companies, based on market capitalization.

* The 6% cumulative alpha gain in Exhibit B does not equal the cumulative passive loss of 51% minus the active manager loss of 46% in Exhibit A due to the impact of compounding.

While the active manager beat the passive option by more than 6% after fees during the crisis, the investor probably didn’t do much celebrating, having lost 46% during that period. Despite all the difficulty, this period brought some great learning opportunities, such as how investors can benefit from having more exposure to strategies that do not rely on markets going up, such as quality alpha.

Exhibit C combines in a 50/50 weighting the passive Russell 1000 Index manager with a stand-alone, simulated alpha. For the purposes of our example, let’s say our simulated alpha offers similar characteristics to our active U.S. equity manager’s alpha. Similar return pattern — or correlation — relative to other asset classes and similar ratio of return to active risk. However, our simulated alpha is modeled at 12% volatility instead of the 3% tracking error relative to the benchmark realized by the active manager. While there are alpha strategies that target these types of characteristics, few offer an extensive enough history to perform our analysis. To further penalize our simulated alpha, we have applied annual fees of 2%, which is higher than the median expense ratio of 1.7% for the most recently reported Annual Report Net Expense Ratio figures from the Morningstar Multialternative Universe.

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Source: Columbia Management Investment Advisers, LLC, November 2013. Past performance does not guarantee future results. This example is for illustrative purposes only and is not representative of any particular investment or product.

While there was some modest give-up in total return, on a risk-adjusted basis the 50/50 portfolio was far more consistent and experienced a more tolerable 9% loss — considerably less than the 51% for the passive only option — over the same time horizon. Furthermore, the 50/50 was reaching new highs later in 2009 while it wasn’t until early 2012 that the passive equity option had fully recovered to its previous peak.

As most investors know, finding quality alpha is very difficult. The purpose of this example is to highlight the power of finding sources of return that do not rely on markets to go up to make money, though that should not be construed as they will always make money. But if we do find quality alpha — either standing on its own or packaged with a market beta — it can change the complexion of one’s investment experience.

Through greater investment innovation across the industry, more impactful alpha strategies now exist. When quality alpha is found, it should be embraced as a powerful tool to help build more resilient portfolios.

 

 

 

Matt Scales

CFA, Head of Product Development and Strategy
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