It is well known that alpha — the measure of a portfolio manager’s success (or failure) in beating the performance of the broader market he or she invests in — is the holy grail of active portfolio management.
Managers who generate enough alpha to beat the returns of low-fee index funds by more than their own fees demonstrate that active fund management can — and does, in these circumstances — represent a better value than passive index investing.
But like the holy grail, alpha is elusive. It is difficult to generate in the first place, and even more challenging to reliably replicate. In fact, while it’s easy to measure a portfolio’s overall alpha, no one has systematically identified where in the manager’s decision-making process that alpha is actually originating.
The source of alpha — the single most important determinant of successful active portfolio management — has been shrouded in mystery.
The Essentia research team has concluded a three month examination of the origins of portfolio alpha — where in the myriad decisions made and actions taken by portfolio managers it tends to be generated or destroyed.
Our results were twofold. First, we found very few common sources of alpha across portfolios. With a handful of exceptions — which we’ll discuss below — most portfolios have their own unique fingerprint of what leads to the alpha they create (or lose).
Second, and most importantly: in 100% of the portfolios we studied, we identified at least one factor — or categorizer, in our terminology — that significantly impacted alpha, for better or for worse. This has profound implications for all active portfolio managers. Our work shows that it is possible for managers to identify where in their decision-making process they tend to create or destroy alpha — and once that is known, the door is open for them to expand or enhance what adds alpha, and correct what diminishes it.
Our study analyzed 60 portfolios over 14 years and identified distinct areas of manager decision-making directly tied to the alpha generated (or lost) within each portfolio. We tracked 24 categorizers – ranging from equity sector to holding period to decision day of the week — across six broad investment decision categories, or skills: stock picking, size adjusting, entry timing, exit timing, scaling in and scaling out.
Sources of alpha were found in varying degrees across six key investment skills among the portfolios we analyzed. This chart shows the percentage of the portfolios in our study that contained at least one significant factor within a given skill.