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Alpha Theory Stock Selection Index – Performance Update
The Alpha Theory Stock Selection Index evaluates managers' stock selection skill in a market-neutral strategy. This update reviews its 2024 performance, highlighting diversification, volatility reduction, and market challenges.
In November 2023, we introduced the Alpha Theory Stock Selection Index to showcase the stock selection skill of Alpha Theory managers (link). In this blog, we provide an update on the index’s all-time performance and highlight its results for 2024.
Understanding the Alpha Theory Stock Selection Index
As a refresher, the Alpha Theory Stock Selection Index is an equity market-neutral strategy, constructed by equally weighting all manager holdings on both the long and short sides (100 long, 100 short). This equal-weight approach removes the impact on position sizing and market exposure, offering a clearer measure of the average manager’s stock selection skill.
Cumulative Performance Overview
The cumulative returns of the index (yellow line in the chart) demonstrate its ability to generate consistent, low volatility returns over time, suggesting that Alpha Theory managers excel at stock selection.
Examining the portfolio statistics (table below), we observe the benefits of diversification in the total portfolio. The long and short portfolios have a near-perfect inverse correlation (-96.5%). This strong relationship significantly lowers the combined portfolio’s volatility compared to the standalone long and short portfolios (5.0% vs. 15.8% and 18.1%, respectively).
The combined portfolio delivers a positive return of 101.2%, lower than the long portfolio’s 187.2% return and higher than the short portfolio’s –48.8% return. But the volatility of combined portfolio is one-third of the long or short portfolios. The reduction in volatility results in a Sharpe ratio 2x higher than both the long portfolio and the MSCI ACWI Index (1.26 vs. 0.62 and 0.67, respectively).
As another way to compare the benefits of low volatility, we boosted the combined portfolio by 3x to equate to the 16% volatility of the long portfolio (5% volatility x 3 = 15%). That would result in returns over 300% and a CAGR over 18%. This is crude math, and, of course, there are financing costs that may bring that total down, but this is a very large boost to returns and a reason why we’re seeing more assets flow to multi-manager and market-neutral strategies (see our December blog on the topic).
2024 Performance Breakdown
The long and short portfolios returned +18.3% and –15.7%, respectively, leading to a total portfolio return of 2.2%.
For comparison, the MSCI ACWI Index returned 17.5%, outperforming the selection index. The ACWI’s strong performance resulted in a Sharpe ratio of 1.68, notably higher than the 0.3 Sharpe ratio of the selection index.
Are We in a Stock Picker’s Market?
To evaluate managers’ stock selection skills in 2024, we compared recent performance to historical trends, measuring strategy returns relative to the ACWI.
Key findings:
- The long portfolio generated excess returns of +0.8% in 2024, trailing its historical average of +1.9%, with returns typically fluctuating by 7.5%.
- The short portfolio underperformed relative to its historical excess returns (+1.8% vs. +5.8% ± 9.9%).
- The total market-neutral portfolio delivered lower-than-normal absolute returns (2.2% vs 7.1% ± 4.9%), and this underperformance was statistically significant (p = 0.01), below the Bonferroni-adjusted threshold of 0.167.
Conclusion
While Alpha Theory managers have historically demonstrated strong stock selection skills, 2024 was a challenging environment for generating excess returns. The combination of strong broad-market performance (ACWI: +17.5%) and weaker short-side returns contributed to the total portfolio’s underperformance relative to historical averages. Given the statistical significance of this underperformance, 2024 stands out as an exceptionally difficult year for stock pickers.
