Building Modern Portfolios – Three Ways To Generate Alpha
In case you missed the first two segments of this series, the topic at hand is how to go about developing portfolios designed to outperform in today’s modern markets. More specifically, how does a manager attempt to provide outperformance in a world where trading is done at the speed of light and asset class correlations spike whenever an event or market crisis takes hold?
Recall that I had been working with advisors who wanted my team to create a series of risk-targeted, asset allocation strategies that would strive to “be around” the benchmarks during most calendar years and then try to “lose less” when the bears came to town.
At the outset of this series, I opined that while simplistic in nature, the first step in the process is to define the objective, then the benchmark, and finally, the time frame one wants to work in.
On the subject of benchmarks, we explored the importance of identifying and understanding the benchmark you are trying to best. I explained that after years of wrestling with the dilemma of which benchmark to target, I had concluded that benchmarks should be about (a) the risk level a client wishes to employ and (b) the alternatives an investor would have when deciding whether or not to use my investing services. And for me, this means utilizing Morningstar Target Risk Allocation categories.
So, with both the portfolio objective and benchmark established, it is now time to discuss the rubber meeting the road. I.E. How to deliver. In the business of investing, this is called generating alpha.
In simple terms, “alpha” is the value a manager brings to the portfolio that goes above and beyond the “beta” a market 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. For investors that want a return equivalent to the market, they can just “buy beta” via an index fund or ETF.
On the other hand, managers attempt to outperform the index by doing something a bit different 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 that are seeing explosive earnings growth. And so on, and so on. The overall objective is for a manager’s strategy to outperform the market index, thus creating positive alpha.
There are lots and lots (and lots) of ways that managers attempt to skin the alpha cat so to speak. But since I like to try (key word) and keep things relatively simple in this game, I believe there are really only three ways to generate alpha: Timing, Selection, and Leverage.
Timing: When You Buy and Sell
If you ask people what they think about “timing,” you will likely get a fair number of impassioned declarations that timing doesn’t work and as such, one shouldn’t even try. We can actually thank the mutual fund industry for this one as the objective of any fund company is for you to put your money in their funds and leave it there – forever.
Forget about “timing” they say – just buy and hold. (Which again, really means, don’t ever sell our funds – we like the fees we earn on your dough.)
But, and please correct me if I’m wrong here, isn’t the idea of buying low and selling high still a viable concept in investing? Doesn’t everybody want to buy a stock at $10 and sell it at $20? This is the idea behind “timing alpha.”
So, do yourself a favor and dismiss all the hogwash about timing being for losers. The bottom line is that when you buy and when you sell matters – a lot. And it is one of the key ways that managers can create alpha.
Selection: What You Buy and Sell
The next way a manager can potentially create alpha is via security selection. Apple versus Google. Goldman Sachs versus JPMorgan. Stocks versus bonds. Small caps versus large caps. Gold versus silver. Growth versus value. Dividend growers versus payers. In short, these are the decisions that can create outperformance. Or not.
Selection is probably the best known way that managers attempt to generate alpha – and there are a zillion different ways to try and do it. Today, many of these “selection methodologies” are called factors, which is also the latest craze in the ETF industry, allowing you to buy just about any selection method you can dream up in a nice, tidy ETF package.
The bottom line here is that with the exception of passive index managers, most managers utilize some form of selection in their effort to try and generate alpha in their portfolios.
Leverage: How Much You Buy and Sell
Let’s be honest, this one can be a little scary at times. The idea here is to “lever up” a position so that when you “win” you “win big.” This can take a few different forms but traditionally has involved buying securities with borrowed money – i.e. buying (or selling) on margin. And if you’ve ever been forced to meet a margin call, you understand the scary part of such a strategy.
However, nowadays, there is another easier, cheaper way that everyday investors can employ leverage – enter the levered mutual funds and ETFs. These funds are designed to provide a multiple of the return that the underlying index provides on a daily or monthly basis. And you don’t have to borrow money from your brokerage firm to do it – you simply buy the ETF of fund designed to give you leveraged exposure to an index.
For example, if you think the NASDAQ 100 index is the best stock market index to own (which would actually be an example of “selection alpha”) and you think the time to buy is now (this is your “timing 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.
In Sum: There are Three Ways to Create Alpha
While I’m sure that some folks will accuse me of oversimplifying a terribly complex topic, I believe there are basically three ways a manager can create alpha – I.E. attempt to outperform: Timing, Selection, and Leverage.
The key is that if you are correct in your selection, you decide to employ leverage, and you get the timing right, you can potentially create outperformance.
So, when developing portfolios, it is important to 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). But these are the basic tools in a manager’s bag they can use when developing a portfolio.
Next time we will talk about how and when to implement what I call “alpha factors” when building portfolios.
Thought For The Day:
If people aren’t better off with what you are doiong for them, find something else to do. -Wes Hickman
Current Market Drivers
We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).
1. The State of Geopolitical Issues
2. The State of Earning Season
3. The State of Trump Administration Policies
4. The State of the U.S. Economy
Wishing you green screens and all the best for a great day,
David D. Moenning
Chief Investment Officer
Sowell Management Services
Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.
Investment Pros: Looking to modernize your asset allocations, add risk management to client portfolios, or outsource portfolio design? Contact Eric@SowellManagement.com
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