Alpha Theory 2020 Year In Review

Alpha Theory clients continue to outperform! Over the past nine years, Alpha Theory clients have outperformed their peers seven times, leading to over 2% per year performance improvement over the average hedge fund. Over that same period, Alpha Theory’s systematic position sizing outperformed clients’ actual return every year by an average of 6%!

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 (239% vs. 112%) and three times that of the average hedge fund (112% vs. 74%). *Sidenote: 6% per year equals double the returns. Isn’t compounding amazing?

‍2020 was a really good year for clients as they beat the primary Equity Hedge index by 5.0% despite missing out on 2.5% of return if they would have systematically sized positions using Alpha Theory.

Note that the difference in returns between the charts is due to leverage. The chart above is total return (varying leverage per manager). The chart below is based on 100% gross exposure per manager (ROIC) and is thus a better apples-to-apples comparison.

HOW OFTEN DOES IT WORK?

At the end of each year, we sit down with clients and go through an analysis of actual versus optimal performance. The question is how often does optimal outperform. As you can see above, we’ve been reporting on the annual results for nine years and, on average, systematic sizing has won every year. But it doesn’t win for every client and every position. Across all-time, if we randomly select a client in a given year, systematic sizing is better 69% of the time. If we do the same thing but randomly select a position, systematic sizing wins 59% of the time.

This means that our clients have, on average, predictive research because the systematic sizing is based on their forecasts. What we see in the results is the benefit of consistently applying process. The more time spent applying process, the more likely the process is to win[i].

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PROCESS ENHANCES PERFORMANCE

Alpha Theory clients use process to reduce the impacts from emotion and eliminate guesswork as they make position-sizing decisions. Alpha Theory gives a true ranking of ideas in the portfolio, so managers can size them accordingly. It does this with a rules engine that:
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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 sizing process
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Enables real-time incorporation of market and individual asset moves into sizing decisions

Our clients are a self-selecting cohort who believe in process and discipline; process orientation goes together with the Alpha Theory software that serves as a disciplining mechanism to align the best risk/reward ideas with rankings in the portfolio. Below are some of the best lessons for how to turn process into performance.

START WITH PRICE TARGETS

‍Alpha Theory research shows that ROIC for assets with price targets is 7.8% higher than for those without price targets. Some investors chafe at price targets because they smack of “false precision.” These investors miss the point because the key to price targets is not their absolute validity but their explicit nature, which allows for 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.

NEXT, KEEP THE PRICE TARGETS FRESH

Once you establish targets, keeping them fresh matters. See below for a chart comparing Fresh vs. Stale Price Targets (stale is defined as older than 90 days).

FINALLY, CREATE A SYSTEMATIC APPROACH TO SIZING POSITIONS

Once you create a research process based on fresh price targets, the next step is to create a systematic process to highlight when positions are out of line with research. That’s what Alpha Theory does in the form of Optimal Position Sizing. As you can see below, there is a marked improvement in almost every metric with systematic position sizing. Again, this is based on 9 years of data across 100+ managers. We can say with high confidence that the managers using Alpha Theory are great price target forecasters. Still, they could do even better if they followed the system they built in Alpha Theory more closely.

In the future, 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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[i] http://success-equation.com/tennis.html - Tennis match simulator from Michael Mouboussin showing the benefit of compounding small edges.
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