Generating alpha: Managing Money is Not the Old Buy and Hope
Managing your money requires you to define your investment objective, identify the benchmark you’re comparing against, and the time frame you want to work in. Once established, you are ready to deliver. In the business of investing, this is called generating alpha.
Identifying and understanding the benchmark you want to best is very important. For example, the benchmark of a moderate or conservative allocation is very different from a fully “all stock” benchmark like the S&P 500 Index.
After years of wrestling with the dilemma of which benchmark to target, I’ve concluded benchmarks should be about the risk level you want to employ, and your alternatives when selecting a financial advisor. For me this means utilizing Morningstar Target Risk Allocation categories.
What is Alpha?
In simple terms, “alpha” is the value a manager brings to the portfolio that goes above and beyond the “beta”, a market or benchmark itself provides. As an example, a stock market index generates a base-level return for a portfolio. If the S&P 500 gains 10%, then a stock portfolio starts with that tailwind. If you want a return equivalent to the market, you can just “buy beta” via an index fund or ETF.
On the other hand, if you hire an asset manager, we attempt to outperform the index by doing more than simply capturing beta. For example, a value manager believes he/she can add value (i.e. outperform) by identifying stocks that are “cheap” relative to the current market price. A growth manager searches out companies enjoying explosive earnings growth. The overall objective is for a manager’s strategy to outperform the market index or benchmark they are measuring against.
There are many ways to generate alpha, but I believe there are really only three ways:
Timing: When You Buy and Sell
Ask people what they think about “timing”. You will probably get some impassioned declarations that timing doesn’t work. The mutual fund industry can be thanked for this perception. You see, the objective of mutual fund companies is to get your money in their funds and leave it there. They want you to forget about “timing” by buying and holding their funds.
Please correct me if I’m wrong, but isn’t the idea of buying low and selling high still a viable concept in investing? So, isn’t there a degree of timing involved? Doesn’t everybody want to buy a stock at $10 and sell it at $20? This is the idea behind “timing alpha.” It’s the when that counts. (And as a sidebar it seems to be harder to decide when to sell than when to buy for most people.)
Ask yourself the question that no one else will: Knowing what you know now, if you could have sold at the last market top in October of 2007 and bought back in around April of 2009, would you have done it? Oops, timing!
So, do yourself a favor and dismiss all the negative chatter about timing. The bottom line is that timing does matter – a lot. And it is one of the key ways that managers can generate alpha.
Selection: What You Buy and Sell
The next way an asset manager can potentially generate alpha is through security selection. Raytheon versus Honeywell, Goldman Sachs versus JPMorgan. Stocks versus bonds. Small caps versus large caps. Gold versus silver. Growth versus value. Dividend growers versus payers. Domestic versus International. In short, these decisions can create overperformance…or not.
Selection is probably the best-known way managers attempt to generate alpha. Today, many “selection methodologies” are called factors, which is also the latest craze in the ETF industry. This allows you to use just about any selection method you can dream up in a nice, tidy ETF package.
The bottom line here is that most managers use some form of selection in their effort to generate alpha in your portfolio. (The exception being passive index managers.) My view is that investments are tools. If you want to drive a nail into a wall, be sure you use a hammer rather than a screwdriver. There’s much less frustration that way.
Leverage: How Much You Buy and Sell
Let’s be honest, this one can be a little scary at times. The idea is to “lever up” a position so when you “win”, you “win big.” This can take different forms, but traditionally involves buying securities with borrowed money (i.e. buying or selling on margin.) If you’ve ever been forced to meet a margin call, you understand the scary part of such a strategy.
Today there is an easier, cheaper way to employ leverage. Simply enter the levered mutual funds and ETFs. These funds are designed to provide a multiple of the return provided by the underlying index on a daily or monthly basis. The best part is you don’t have to borrow money to do it either. You just buy the ETF of fund designed to give you leveraged exposure to an index.
For example, assume you believe the best time to buy is now (timing alpha) and the best index to own is the NASDAQ100 (selection alpha). You can buy a fund/ETF that provides two or even three times the return of the index. Bam – you’ve got leverage alpha in your portfolio!
Although these investments will go up at the multiple designed, remember it will also decline at that same rate. Again, timing is rather important here. You may need a set of defined rules in order to increase your probability of success.
In Conclusion: There are Three Ways to Create Alpha
I’m sure some people will accuse me of oversimplifying a terribly complex topic. However, , I believe there are basically three ways a manager can generate alpha: timing, selection, and leverage.
The key is if you are correct in your selection, decide to employ leverage, and get the timing right, you can potentially create outperformance.
When developing your portfolio, keep these ways to generate alpha in mind. To be clear, you don’t need to utilize all three methods in every strategy (I’ll go out on a limb and say that most managers don’t). However, these are the basic tools used when developing a portfolio. Know how you intend to approach investing before ever doing it. Then follow your pre-defined rules.