Investment product performance is composed of two very important elements, beta (what the market delivers) and alpha (what the manager delivers). There is a layer of complication to this analysis, however, and it comes from the fact that “what a manager delivers” may be superior security selection, superior beta positioning, or both (or neither).
Investment selection alpha is what the value investing world means when they claim alpha generation. In its simplest form, a portfolio manager selects some subset of securities from the larger set of securities in an index, and if the portfolio manager generates a higher gross return, he has generated alpha relative to that index.
But what if, for example, the manager selects all of the securities in the index, weights them by capitalization (like the index), and balances that against either a significant cash allocation, or a negative cash allocation (leverage)? If the market’s return is positive, the leveraged manager outperforms, and if the market’s return is negative the cash-allocated manager outperforms. If a manager generates a higher gross return, is this not positive alpha? Or, is the portfolio manager better described by the pejorative “beta jockey”?
Investment selection alpha and opportunistic alpha both add significantly to investors’ portfolios, yet superior stock and sector selection grab all the headlines. In fact, generating opportunistic alpha is condemned as “market timing” by those who would not profit from it. I’ve even heard it called “witchcraft” by a PhD who thought opportunistic alpha was about perfectly predicting the market.
No one can perfectly predict the market, as evidenced by the world’s lack of a single trillionaire. Rather, statistical analysis of critical market factors can produce confidence in higher likelihoods of some outcomes. Managers employing an opportunistic approach use such research to position accordingly, and those deviations from their index or benchmark result in alpha (positive or negative).
The challenge with opportunistic alpha, and the primary reason it is underrepresented in investment discussion, is that it is more difficult to measure. The cleanest form of opportunistic alpha is delivered by the managed futures industry. Here, long or short futures positions are taken over a range of timeframes, across a wide array of underlying assets. Since these managers rarely hold core long positions, their benchmark – and beta – is the risk free rate. Anything generated above (below) this rate is positive (negative) alpha. Not only does this alpha spend the same way investment selection alpha does, it further diversifies by being uncorrelated.
The lack of correlation is driven by the fact that investment selection alpha is sought consistently throughout all periods of the market. Whether the market is down 20%, flat or up 20%, investment selection alpha is generated if returns are -19%, 1% or 21%, respectively (assuming the same volatility). Visually, investment selection alpha shifts the return distribution to the right.
Significant opportunistic alpha tends to be generated during outsized market moves, resulting in a positive skewing of the return distribution. Truncating the left tail and extending the right tail is how opportunistic alpha reshapes the return distribution, rather than shifting it.
Another technique that can generate opportunistic alpha is rebalancing. Relative to what would normally occur in a client’s portfolio, such as an annual rebalance, an approach based on studied market factors that seeks to exploit market moves that have already happened can generate as much alpha as the work done on investment selection. All investors benefit from increased alpha, and reallocating some of the focus from investment selection alpha to opportunistic alpha could have a significant, positive impact on portfolios.