The Importance of Alpha in Your Portfolio
Why is alpha so important?
Max: Alpha – performance beyond market-driven returns – is always important, even if beta returns have been so strong that the relatively stable alpha contribution seems insignificant by comparison. We have not had a low return environment since the global financial crisis and that isn’t going to perpetuate.
Celia: That’s right. Alpha acts as an incremental return source over and above what the beta gives you. Alpha doesn’t scale with beta, so it becomes a smaller percentage of returns when beta is very high. When markets get extended they must come down to reality. It is particularly over those environments that alpha makes a big difference. In the long run, alpha returns are worth the significant effort to get them.
Max: We believe that institutions concerned about delivering on their long-term investment objectives should devote attention to evaluating active managers that are not benchmark-focused. Careful selection among such managers is the key for long-term returns and sustained alpha generation.
How have the strong returns from U.S. equity investment strategies changed your perspective on alpha-generating strategies?
Max: They haven’t. In fact, the enormous beta returns from U.S. equities over the past five years have probably strengthened our view. When market returns are lower, alpha is that much more valuable.
Celia: Some investors have elected to allow the U.S. equities bull market to put the search for alpha on the back burner. It’s understandable: The U.S. public equities market has returned about 250% since March 2009. However, piling into U.S. equity index strategies now means investors will only obtain market returns in a more difficult, lower-return environment. And such an environment is inevitable, if not imminent. In fact, we’re seeing many institutions turning up the heat on their search for alpha as a result.
What are the most important elements of the pursuit of alpha today?
Max: There are a number of elements that are important. For example, it is critical to have the resources in place to identify alpha generating managers. Another is to maintain a consistent process across varying market environments in order to avoid unnecessary transactions and possibly being whipsawed.
Celia: You need to have a world class research effort to be able to evaluate the best array of managers that are all seeking to outperform the market. We seek to understand how they add value, what kinds of risk premiums they are trying to capture, and whether their edge is sustainable.
Max: As long as they can stay true to the process, a broad swath of active managers can generate outperformance.
Celia: We are also highly attuned to market valuation cycles. Chasing past performance when valuations are very pricey can be a failed strategy. For instance, there are a number of equity markets that are significantly less expensive than the U.S. stock market that offer better fundamentals, offering the potential for stronger returns. Japanese equities, for example, returned about 13% in the first half of 2015, compared with less than 1% for U.S. equities.
Do you advocate active managers in the pursuit of alpha?
Celia: Pursuit of high quality active managers is central to our alpha generation activities. Indexing strategies certainly have a place in portfolios as an inexpensive means to access markets and re-adjust market exposures. Our preferred mix of index and active strategies depends both on investors’ risk tolerance and the market environment.
Max: My inclination toward active managers on the public market side tends to be toward managers that have high active share. They are usually smaller organizations, often where the founder is an investor first, so they bring their investing acumen to bear. Their businesses are structured to be consistent with the best interests of investors. We very much like that. And since even the best managers can go through periods of underperformance, it’s also important not to be too quick to fire managers on the basis of performance; if you hire and fire at the wrong time, you risk locking in losses or losing out on the potential to generate alpha in the future.
What common missteps do investors make in an environment in which beta has been so productive?
Celia: The most common mistakes involve getting caught up in momentum without concern for valuations. For instance, continuing to pile into strategies that worked well throughout the bull market, even after valuations approach very high levels, could be a mistake. Investors would be better off rebalancing periodically to lock in gains and when valuations reach extremes, underweighting such strategies to fund more attractively valued investments.
Max: Another tendency that could trip up some investors is making blanket assumptions and generalizations about an entire asset class or investment strategy. In today’s environment, some investors have recently given up on hedge fund strategies. This may be unwise. First, it is counterproductive to consider hedge funds a monolithic asset class, since there is a broad diversity within the set of firms that we group together as “hedge funds.” In addition, when the dispersion among stock performance widens, hedge fund managers are likely to generate better alpha. The bottom line is that it’s important to take a long-term view and employ a consistent process all along the way.