This is a continuation/republish of our March blog, “20% of Top 15 Hedge Funds are Alpha Theory Clients” where we highlighted that three of the Top 15 Hedge Funds over the past three years are Alpha Theory clients.
Our friends at Novus, who put out great research, released their first quarterly analysis of hedge fund performance. In their Q1 2015 report, eight Alpha Theory clients are in the Top 50 hedge funds. Based on the size of our client base, we would have expected less than one* Alpha Theory client to be on the list but our clients actually make up 16% of the Top 50 (8/50). While we recognize that one quarter does not a trend make, we have seen empirical and anecdotal evidence of our clients’ outperformance due to their focus on value, process, discipline, and unemotional decision making.
There are two benefits reinforced by Alpha Theory which may explain why our clients are so prevalent on this list. The first is better position sizing. Performance results are a function of Stock Selection + Position Sizing. Position Sizing is often an instinctual assessment (“best guess”) of amalgamated information processed in a portfolio manager’s head. Making it even more complicated, pricing and information is constantly in flux. Genius or not, the task of sizing positions through mental (instinctual) calculation is subject to error and bias. Position Sizing is less than optimal for funds using instinct based decision processes because their Transfer Coefficient (the correlation between the fund’s assessed idea quality and the position size) is much less than 1. For Alpha Theory clients, the Transfer Coefficient is much closer to 1 which maximizes the alpha tied to position sizes.
The second reason why Alpha Theory customers are outperforming their peers is process. Each of our customers develop a custom process that automatically highlights when positions are mis-sized, forces conversations when price objectives are breached, or creates a framework for discussing ideas based on their probabilistic outcomes. It is difficult to create discipline without process and our clients are able to do both and outperform because of it.
We’ve measured the performance improvements that come with better position sizing and they’re real. We’ve seen it from real-world analysis of our clients where performance improvements averaged over 7%. We’ve run Monte Carlo simulations which suggest that tightly coupling idea quality and position size can add 2-6% of additional alpha (this even assumes that price targets and probabilities can be off by up to 50%).
Everyone recognizes that position sizing is important and a growing number of hedge funds are starting to do something about it. Imagine two hypothetical hedge funds that have both performed the exact same research. The firm that has a better process to translate that research into a portfolio is going to win every time (assuming the research is reasonably accurate). Process and discipline will be the hallmark of many of the future hedge fund superstars. If you don’t have a structured process now, it is important to start soon. The move towards a more logic-driven decision process has already begun and the winners are starting to show up in the data.
* Assuming that there are approximately 10,000 hedge funds worldwide according to HFR.com.