Performance During The Pandemic (Part 2)

Optimal Position Sizing During the Pandemic

Every investor uses mental models that dictate their investment process and portfolio composition. When investment managers join Alpha Theory, they work with our Customer Success team to make those mental rules explicit in the form of a model. This forces managers to think about their process, and to be honest with themselves when they are not following their own rules.
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These models are defined by variables like position size, liquidity, investment checklist, and analyst price targets, to name a few. The output of the model is a suggested optimal position size (OPS), which allows managers to make sure their actual position size (APS) reflects their research and investment process. In the Concentration Manifesto, we outline our research on how managers would benefit by concentrating their holdings in their best ideas. The OPS models created for every fund tend to suggest larger position sizes for names with a higher probability-weighted return and can suffer from higher volatility when markets undergo a sharp correction.
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When markets are as volatile as they have been this year, having a way to highlight dislocations between research and position size is more important than ever. The market has declined roughly 4.5% (as of 7/24) since the high in February, whereas our average long/short manager is up by 1.5% over the same period. Had our clients followed the model verbatim, they would be up, on average, by 5.9%.

Paying closer attention to the feedback loop provided by the optimal position sizing model would have led to significant improvement for the bottom quintile. The OPS models for these clients, based on their own research and investment process led optimal to outperform by roughly 20%.  

Digging in a little further we see that the bottom performer’s actual and optimal long exposure moved in opposite directions. As markets reached their nadir in mid to late March, OPS recommended increasing exposure to the market while the managers were decreasing exposure. Alpha Theory then recommended decreasing exposure as prices recovered. This resulted in their long book losing 14% while the Alpha Theory long book made +6%!

This is because optimal position sizes are based in part on the expected value of a security. If you liked a stock at $100, you love it at $70. As the market went down, expected returns went up, so the models increased exposure. This is one of the key takeaways for how Alpha Theory can help clients avoid emotional decisions, and to invest based on their own research.
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This remains a difficult environment and we believe that during times of stress, implementing protections against emotional investment decisions is critical to success. Investors in the top quintile used their research as their anchor, did not overreact, and added to their high conviction names when things seemed bleak.  Process-driven investing, as we practice at Alpha Theory, helps to mitigate the impact of emotions and helps managers harvest more of the alpha they deserve from their research.

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