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Alpha Theory Stock Selection Index
In this article, Cameron Hight, Justin Olson, and Aaron Hirsch present the Alpha Theory Stock Selection Index. This index was created to better understand the stock selection skill that has been observed among Alpha Theory managers.
We are excited to present the Alpha Theory Stock Selection Index. We created this index to better understand the stock selection skill we’ve observed among Alpha Theory managers.
To create this index, we took the equity holdings of all managers and split them into long and short portfolios. For each day, we then equal-weighted positions by side and created a 100 by 100 equity market-neutral strategy, where the total EMN portfolio is the spread between the long and short portfolios. This equal-weight approach eliminates the impact of position sizing and market exposure, allowing us to better understand the average manager’s stock selection skill.
The resulting index suggests that Alpha Theory managers excel at stock selection. The yellow line in Figure 1 represents the performance of the Alpha Theory Stock Selection Index. The index generates positive, low volatility returns across time which indicates that Alpha Theory managers are good at picking durable and consistent stocks.
To better understand the return stream, we performed a series of analyses that can be observed in Table 1. Here, we observe the benefits of portfolio diversification in the performance metrics of the total portfolio. Since the long and short portfolios have near-perfect inverse correlation (corr.: -0.96), the combined portfolio has muted volatility (4.72% vs 15.81% for the long portfolio and 17.88% for the short portfolio). The combined portfolio also realizes improved returns (115.8% vs 113.9% and 23.4% for the long and short portfolios, respectively). This decrease in volatility and increase in returns produces a 3x increase in the Sharpe ratio compared to the long portfolio and ACWI (1.68 vs 0.5 vs 0.42, respectively).
The Alpha Theory Stock Selection Index illustrates that Alpha Theory managers have persistent stock selection skill. We see this in the alpha generated on both sides of the book, which was +0.83% on the long side and +4.60% on the short side. Combining the two portfolios creates a high Sharpe return stream (as seen in the consistency of the yellow line in the chart) that could be leveraged to generate higher overall returns. Look for continued reporting on the Alpha Theory Stock Selection Index in the future.
