.svg)
The Ultimate Position Sizing Guide - Part 1: Sizing Matters, But How Much?
Position sizing is a critical yet often overlooked driver of investment returns. In this section, we explore why it deserves the same rigor as security selection, using data and insights from top fund managers to highlight its impact on portfolio performance.
In a world of ever-increasing complexity, it helps to zoom out and simplify. At its core, investing success comes down to two key factors: what you invest in and how much you invest in it. Security selection and position sizing. While extensive research exists on stock selection, position sizing often takes a backseat. Why is that? If both are important factors in determining your investment outcomes, surely, they both deserve rigor and appropriate resource allocation.
At Alpha Theory, we believe they should. In this three-part series, we will lean on Alpha Theory’s unique set of manager data, as well as our experience gained working with hundreds of fund managers. We’ll define, outline, and unpack the best practices in position sizing, what drives position sizing alpha, how much excess return is left on the table, and best practices for improving your position sizing approach.
Understanding Position Sizing
Position sizing determines how much capital to allocate to each investment relative to others in the portfolio. Think of it like baseball: if security selection is your batting average (how often you pick winning stocks), position sizing is your slugging percentage (how much return you extract from your picks). The best investors not only select great stocks but also optimize their portfolio allocations to maximize returns.
Position sizing, however, often remains an afterthought. Why? Most portfolio managers (PMs) begin their careers as analysts focused on individual securities, understanding their business drivers, and valuation potential. But, when they transition to the PM seat, they must develop portfolio construction skills like timing and sizing on their own. This lack of structured training means that many PMs default to gut instinct when sizing positions, leaving valuable alpha on the table.
Why Sizing Matters
To quantify the impact of position sizing, we analyzed 13 years of data from approximately 200 Alpha Theory equity managers. We broke performance down into three components: stock selection, discretionary position sizing, and systematic position sizing. Using the MSCI Equal-Weighted All-Country World Index (ACWI EW) as a benchmark for market selection skill, here’s what we found:
- Alpha Theory managers outperform the market’s selection skill by +1.6% annually.
- The median actual portfolio outperforms an equally weighted version by +2.0%, proving that sizing decisions add value.
- A portfolio using systematic position sizing outperforms manager sizing by 1.2% annually (CAGR of 13.7% vs. 12.5%).
Over the period, sizing decisions contributed 60% of the outperformance relative to a naïve equally weighted portfolio. This confirms a crucial insight: picking good stocks is essential but sizing them well is what separates great investors from merely good ones.
The Role of Structured Sizing Frameworks
How can PMs implement a more structured approach? The first step is recognizing that most sizing frameworks today are informal. Many funds rely on periodic portfolio reviews, where positions are adjusted based on meetings, intuition, and scattered data points. While this adds some structure, it lacks the rigor needed to consistently optimize position sizes.
A more systematic approach involves leveraging quantitative frameworks such as Mean-Variance Optimization (MVO). Originally developed by Harry Markowitz, MVO provides a data-driven method for determining optimal position sizes based on expected returns, volatility, and correlations. While MVO is widely used in quantitative investing, models often fail to align with fundamental investors' priorities. The key is to balance systematic rigor with a PM’s insights.
Can We Prove That Structure Improves Returns?
Skeptics may argue that their current ad hoc approach works just fine. The analysis cited above showed that, for their long portfolio, our clients generated +200bps of sizing return vs 33bps for the 1200 funds analyzed by Novus. This is solid proof that structure matters.
To further test whether structure improves returns, we conducted a study comparing the long/short portfolios breaking it down into three cohorts:
- General hedge funds: non-clients, likely using traditional discretionary sizing.
- Alpha Theory clients: funds using our platform, though not always adhering strictly to the optimal weights.
- Systematic Alpha Theory portfolios: hypothetical portfolios following optimal weights with full adherence.
The results were clear. Systematic Alpha Theory portfolios outperformed general hedge funds by +600bps annually. They also outperformed Alpha Theory clients by +400bps annually, suggesting that even our clients, while benefiting from structure, could unlock further alpha by adhering more closely to optimized sizing recommendations.
This data underscores an important takeaway: adding structure to position sizing decisions is a high-impact, low-effort way to enhance portfolio performance.
The Bottom Line
Position sizing is not just an afterthought. It’s a fundamental driver of investment success. Download Part I of the white paper to explore this topic further.
In the next part of the series, we'll build on the prior work, further quantifying the value add of a rigorous position sizing process and the importance of having the right tools in place. Follow Alpha Theory's LinkedIn page as we continue to explore best practices that can help you unlock position sizing alpha in your portfolio.
.png)
