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Alpha Theory 2024 Year in Review
Discover key insights from Alpha Theory’s 2024 Year in Review, including optimal position sizing performance, portfolio trends, and lessons learned from the past year. See how data-driven decision-making continues to drive better investment outcomes.
For the thirteen years of Alpha Theory’s historical dataset (2012-2024), a portfolio using Alpha Theory’s optimal position sizing outperformed clients’ actual sizing by an average of 4%. Optimal position sizing has demonstrated a 92% win rate, outperforming twelve of the past thirteen years. In 2024, optimal was basically in line with the average client, with the average client up +14.0% versus +14.1% for the average optimal portfolio.
Because Alpha Theory clients operate with ~125% of leverage vs. the industry median of ~150%, per a 10-year study from Morgan Stanleyi, we use Return on Invested Capital (ROIC) to attempt to adjust to an apples-to-apples comparison.
The goal of publishing our data is to convince active fundamental managers that there is a better way to size positions. Even our own clients leave returns on the table. Over the past twelve years, the compound return is twice that of their actual performance, at 320% vs. 163%, and over 2.8x that of the average hedge fund, 320%ii vs. 113%. (Sidenote: Four percent additional return for thirteen years more than doubles the returns. Isn’t compounding amazing?)
HOW OFTEN DOES IT WORK?
On average, returns from optimal position sizing have topped returns from actual position sizing for 12 of the past 13 years, 92%. But it doesn’t win for every client and every position. If we randomly select a position, optimal sizing wins 56% of the time. And if we randomly select a client, optimal sizing is better 68%iii.
THE 90%
Every active manager has seen the comparison below that 90% of active managers underperform their benchmark (Figure 2). It’s depressing.
Here’s the positive. There is a way to increase the chance that you are not part of the 90%.
Our data (Table 1) suggests that fundamental research and stock picking are not the problem. The Alpha Theory Optimal return is a measure of fundamental research and stock picking skill because the optimal sizes are calculated using the price target forecasts and conviction levels scored by the analysts. The research-based sizing (Optimal) outperforms AT Client Performance by 4% (11.7% vs 7.7%, respectively).
An equal-weighted portfolio, which is pure stock selection and includes no sizing skill, outperforms active managers’ sizing by 1.5% (9.2% vs 7.7%, respectively). Active position sizing reduces returns!
The good news. The data confirms there is research skill. And there is an easy way for managers to get even better returns from their alpha-rich research, as the systematically sized portfolio (Optimal) outperformed the equal-weight portfolio by 2.5%.
PROCESS ENHANCES PERFORMANCE
Alpha Theory clients are a self-selecting cohort who believe in process and discipline. Below are some of the best lessons for turning process into performance.
START WITH PRICE TARGETS
Alpha Theory research shows that positions with price targets outperform those without price targets.
The ROIC for long equities with price targets is 6.3% higher than those without price targets. The outperformance is even greater on the short side, where short positions with price targets outperform by 6.5%!
Some investors scoff 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.
In other words, the practice of calculating a price target and the questions that price targets foster are central to a good investment process.
KEEP PRICE TARGETS FRESH
Once you establish price targets, keeping them fresh will further increase performance.
We observed a notable increase in ROIC for long and short equity positions, where fresh price targets were associated with an ROIC increase of 1.7% and 3.7%, respectively, compared to their stale counterparts (Figure 3).
ALIGN POSITION SIZE WITH IDEA QUALITY
The next step is to create a systematic process to highlight when positions are out of line with the research. That’s what Alpha Theory does in the form of optimal position sizing, as explained in more detail in Turning Intuition into Alpha.
SYSTEMATIC POSITION SIZING OUTPERFORMS
Systematic position sizing (Optimal) outperforms actual position sizing in key metrics, including ROIC, batting, slugging, and returns from the average winner (Table 3).
These findings, observed over thirteen years, 200+ managers, and over 1 million price targets, give us confidence in the value investors can realize by more closely following the system they built in Alpha Theory.
Systematize Your Process
Become a part of the 10% of managers that outperform their benchmark. Let Alpha Theory help you systematize your process and discover alpha hidden in your portfolio.
Footnotes:
i Morgan Stanley Hedge Fund Report, Dec 2019
ii The optimal trading strategy will only make a trade when the change in OPS is greater than 50 bps from the previous day, and assumes trading costs of the lesser of 10 bps or three cents per trade
iiihttp://success-equation.com/tennis.html - Tennis match simulator from Michael Mauboussin showing the benefit of compounding small edges.
