Alpha Theory 2019 Year In Review

Alpha Theory clients continue to outperform! Over the past eight years, Alpha Theory clients have outperformed their peers seven times, leading to an almost 3% per year performance improvement over the average hedge fund. Over that same period, Alpha Theory’s suggested optimal return outperformed our clients’ actual return every year by an average of 5.5%!

What does this mean? Our clients are self-selecting, better-than-average managers that would be world-class if they more closely followed the models they built in Alpha Theory.
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In fact, over the period, the compound return is twice that of their actual performance (174.8% vs 85.6%) and three times that of the average hedge fund (174.8% vs 51.3%). *Side note: Isn’t compounding amazing?
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2019 was a really good year for clients as they beat the primary Equity Hedge index by 5.9% despite missing out on 3.4% of return if they would have more closely followed Alpha Theory.
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Note that the difference in returns between the charts is due to leverage. The chart above is total return (varying leverage per manager) and the chart below is based on 100% gross exposure per manager (ROIC) and is thus a better apples-to-apples comparison.

PROCESS ENHANCES PERFORMANCE

Alpha Theory clients use the process to reduce the impacts from emotion and guesswork as they make position sizing decisions. Alpha Theory highlights when good ideas coincide with the largest position sizes in the portfolio. This rules engine codifies a discipline that:

1.    Centralizes price targets and archives them in a database

2.    Provides notifications of price target updates and anomalies

3.    Calculates probability-weighted returns (PWR) for assets and the portfolio as a whole.

4.    Enhances returns

5.    Mitigates portfolio risk

6.    Saves time

7.    Adds precision and rigor to the sizing process

8.    Enables real-time incorporation of the market and individual asset moves into sizing decisions.
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DISCIPLINED USAGE REDUCES RESEARCH SLIPPAGE

Our clients are a self-selecting cohort who believe in process and discipline; process orientation goes together with Alpha Theory software that serves as a disciplining mechanism to align the best risk/reward ideas with rankings in the portfolio. Shown below, the most active users as measured by frequency of updates, research coverage, and model correlation have the highest ROIC.
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Alpha Theory’s research not only suggests that the adoption of the Alpha Theory application by itself leads to improved performance, but actual usage intensity further enhances results.
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Usage intensity is determined by:

1. Percent of Positions with Research

2. Correlation with Optimal Position Size

3. Login Frequency

1.    Measured as the annualized ROIC where data was available, for a sample of 48 clients, 12 for each quartile
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OPTIMAL POSITION SIZING REDUCES RESEARCH SLIPPAGE

Comparing clients’ actual versus optimal returns shows:
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HIGHER TOTAL RETURNS

ROIC is 4% higher.

IMPROVED BATTING AVERAGE

Batting Average is 9% higher. Explanation: many of the assets that don’t have price targets or have negative probability-weighted returns (PWR) are held by the fund but recommended as 0% positions by Alpha Theory. Those positions underperform and allow Alpha Theory’s batting average to prevail.

1.    Measured as the average full-year return for clients where full-year data was available, adjusted for differences in exposure, net of trading costs

2.    Before trading costs
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PRICE TARGETS REDUCES RESEARCH SLIPPAGE

Alpha Theory has further found that ROIC for assets with price targets is 4.8% higher than for those without price targets. Some investors chafe at price targets because they smack of “false precision.” These investors are missing the point because the key to price targets is not their absolute validity but their explicit nature which allows for an objective conversation of the assumptions that went into them. Said another way, the requirements of calculating a price target and the questions that price targets foster are central to any good process.

Finding alpha will not become easier. It is imperative that the funds of the 21st century develop plans to evolve to new realities. Data and process are critical to that evolution. Let Alpha Theory help you and your team grow to meet the challenges of tomorrow.
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