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Alpha Theory Blog - News and Insights

6 posts categorized "Analytics"

September 14, 2017

Asset Manager Reliance on Human Judgement vs Machine

Asset management is the industry most reliant on human judgement according to a recent Price Waterhouse study on Data Analytics.

 

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Asset managers rely on human judgement 3x more than the next industry. For an industry with some of the best and brightest, we seem to be far behind. There is no expectation that this will happen overnight, but at a bare minimum we need to be experimenting with ways to enhance our judgement with machines.

Alpha Theory has been doing just that for over 10 years and our clients have outperformed the average hedge fund by over 2x. Getting started is not hard. Adopting “machine” does not require a wholesale change as all of our clients operate with Man + Machine. What it does require is an acceptance that Man alone is generally inferior to Man + Machine and a cultural embrace of the “machine” as an enhancement to the daily judgements we all make.

The reliance on human judgement will fall over time for asset managers. Do not be the last the change.

 

 

March 13, 2017

Ted Seides - Alpha Theory Book Club

 

On March 7th, Alpha Theory hosted a book club with over 30 portfolio managers, analysts, and allocators coming together to discuss Ted Seides’ book, “So You Want to Start a Hedge Fund?”. We were lucky enough to have Ted present and answer questions about the capital raise environment, investment process best practices, hiring, keeping investors happy, etc.

 

Here are a few takeaways:

 

1. CAPITAL RAISE ENVIRONMENT: It’s hard out there and isn’t getting any easier. Allocators are getting pressure from their investors about their hedge fund investments.

2. INVESTING ENVIRONMENT: Once again, it’s hard out there and isn’t getting any easier. There are more smart managers than ever looking at the same ideas.

3. FEES: Fee pressure will continue and managers will be asked for fee strategies which better align the interests of the investor and the manager.

4. DURATION DISCONNECT: There has been, and probably always will be, a disconnect between the duration that a manager is judged and the duration in which a manager manages their portfolio. The best thing a manager can do is be open and honest about their challenges so that investors get comfortable with volatility of performance numbers.

5. TURNOVER: Managers should be quick to remove “bad fit” analysts, even if they’re going to get push-back from investors over changes with the team.

6. STASIS: Many hedge funds have a “set it and forget it” mentality towards culture, personnel, and investment process. Many great corporations have advanced human capital strategies and hedge funds can leverage that knowledge to build superior organizations (i.e. Bridgewater or Point72).

7. COACHES: To prevent stasis, it is important to read and sometimes bring in outside help. There are experts in team building, time management, bias mitigation, decision science, investment process, etc.

8. RUNNING A BUSINESS IS HARD: Most hedge fund managers don’t have the luxury of just picking stocks. They’re charged with hiring/firing, raising capital, investor relations, human resources, picking accountants, selecting offices, etc. All the things that a CEO of a company deals with plus managing a fund. The reason portfolio managers are so busy is because they have two full time jobs.

9. THE BET: As most know, Ted was the other side of the famous 10-year bet with Warren Buffett pitting the S&P 500 against a basket of hedge fund allocators. Ted still fully believes that hedge funds can outperform in the right environments (i.e. market is overbought).

 

Thanks to all those that attended and contact Alpha Theory if you would like to learn more about attending future book clubs.

 

February 24, 2017

Stock Picking is Hard

 

Stock picking has never been so hard.

 

From a recent interview with Charlie Munger of Berkshire Hathaway:

“In the old days, I frequently talk to Warren about the old days, for years and years and years what we did was shoot fish in a barrel. It was so easy we didn’t want to shoot fish while they were moving. We waiting until they slowed down and shot at them with a shot gun. It’s gotten harder and harder. Now we get little edges. It isn’t any less interesting. And we do not make the same returns we made when we’d pick this low hanging fruit off trees that offered a lot of it.”

“I used to say, ‘you have to marry the best person that will have you.’ That’s a rule of life. You have to get by on the best advantage you can get. Things have gotten so difficult in the investment world.

 

From a recent article on investing by Ben Carlson of CNBC:

Michael Mauboussin calls this the paradox of skill. Mauboussin says, "It's not that managers have gotten dumber. It's precisely the opposite. The average manager is more skillful than in past years. The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results." How many institutional investors bother to ask themselves if the investment managers they are investing with are lucky or truly exhibit skill?

Active managers are competing against many more managers these days than they did in the past. There are roughly 300,000 investment professionals worldwide (portfolio managers and analysts) working for hedge and mutual funds (Alpha Theory estimate). There are 43,000 exchange listed public companies5. That works out to about 7 analysts for every stock! Asset prices become more efficiently priced when lots of smart people pay attention. With those odds, it is no wonder that there is a dearth of good ideas.

 

From Daniel Chambliss’s paper on “The Mundanity of Excellence”:

“Superlative performance is really a confluence of dozens of small skills or activities, each one learned or stumbled upon, which have been carefully drilled into habit and then are fitted together in a synthesized whole.”

“Excellence is accomplished through the doing of actions ordinary in themselves, performed consistently and carefully, habitualized, compounded together, added up over time.”

It has never been more important to do the little things that lead to success. Alpha Theory’s dominant beneficial attribute is the process discipline it instills in our clients. Our clients have outperformed the HFRI Index for each of the last five years (as far back as we have data) by an average of 3%. I believe their discipline is a big part of what makes them excellent. As good as they are, they can be better. If they would have strictly followed their models, their performance would have been 6% higher. There is alpha out there for the good stock pickers but it requires discipline and a desire to be excellent.

 

January 31, 2017

ALPHA THEORY - 2016 YEAR IN REVIEW

Client Outperformance

For the fifth year in a row (as far back as we have data) our clients have outperformed the HFRI Equity Hedge Index. To date, our clients’ compound return is 20% greater than the index.

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As good as our clients are, they would have been even better if they followed the optimal position sizes they built inside of Alpha Theory:

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On average, Alpha Theory suggests a lower gross exposure. So, to compare on an apples-to-apples basis, we look at Return on Invested Capital. For 2016, the Optimal ROIC was 13.3% versus 6.5% actual. That’s a difference of 6.8%.

Let’s put that difference into perspective. Our clients manage over $100B using Alpha Theory. On an ROIC basis, 6.8% of additional return on $100B is $6.8B. Assuming 20% performance fees, our managers left almost $1.4B of income on the table.

In 2016, 84% of our clients would have performed better if they would have followed optimal position sizing.

Betting the Forecasting Edge

Lastly, 2016 was the best year on record for the correlation between our clients’ forecasts and actual returns. The correlation between expected and actual returns was 0.19 for 2016. While this may seem low, one would expect a correlation near zero if selected randomly. For every year since 2012, with the exception of 2015, the correlation between expected and actual returns has been positive.

We believe this is a strong indication of predictive power in analysts’ forecasts. If analysts’ forecasts were random, then optimal position size would not beat actual returns with such regularity.

There are many ways to try and improve but few are as easy as creating a discipline around position sizing. The evidence is clear, if a firm has any edge, then creating a repeatable process to bet that edge is the difference between good and great.

Additional Portfolio Metrics

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December 28, 2016

2017 NEW YEAR’S RESOLUTIONS

By Emma Vosburg and Cameron Hight

 

Every year, people make New Year’s resolutions and every year, people break them. Creating positive habits that reinforce resolutions is the difference between the people that keep their resolutions and those that break them.

Creating process that works for you is the key to forming habits that lead to accomplishing your goals. You must commit to the process. For investors, a lack of systematic investment process means it will be difficult to consistently outperform your competitors. Alpha Theory is process in a box!

Let us help you create a winning process and build the habits necessary to fulfill your New Year’s resolutions. Let’s look at a list of possible Alpha Theory New Year’s goals:

CREATE PROCESS ----> BUILD HABITS ----> ACHIEVE GOALS

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Why make an Alpha Theory New Year’s resolution? Alpha Theory’s research not only suggests that adoption of the application by itself leads to improved performance, but actual usage further enhances results. In the table below, we show that clients who are more process oriented (as measured by having price targets, frequency of review, and diligence at updating position size based on their forecasts) outperformed our clients who were less diligent.

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A systematic approach to accomplishing goals is valuable in every aspect of life. In 2017, create process that builds habits and allows you to achieve your goals. No excuses!

 

November 30, 2016

Using Analytics to Improve Investment Process

By Cameron Hight and Justin Harris

 

Data is taking a precedence in modern life as a necessity for those who want to improve. With specific relevance to asset management, finding insightful feedback in data is where managers can use unbiased facts to flesh out the inefficiencies in their investment process. As more and more managers rely on data to inform their investment process, the cost of not doing so increases. We, at Alpha Theory, have spent considerable time over the past year working with clients to help them hone their process, based on insights from data. Here are a few examples:

PROBABILITY AND FORECAST ANALYSIS

Alpha Theory uses analyst forecasts to optimize portfolio position sizing. Managers must therefore know what confidence they can put on analysts’ research, because optimizing on bad research could be deleterious to returns.  Said another way, managers need to know who to trust.

As a starting point, the average analyst in our system forecasts that they’ll make money on their investments 75% of the time compared to their actual success rate of 53%. Additionally, they forecast upside returns of 43% compared to their realized returns of 26%. Clearly there is a pervasive, systematic overconfidence. With that perspective, you can evaluate your own team.

Probability Analysis. One of the first areas to evaluate is the forecasted probability of making money compared to the actual percentage of investments that were profitable. In the graph below, we show a representative comparison of forecast versus actual success rates. As a manager, this is excellent information because in one glance, you see which analyst is most accurate and who has the most bias. The actionable information would be requesting that Jimmy and Matt cap their forecasted success percentage at 50% and reviewing specific names with Jim to see why he has such dramatic bias.

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Additional analyses could include long/short and sector breakout or alpha-based analysis. These additional insights may help clarify the analyst’s differences. The point is that you ask questions based on empirical data that help your analysts improve while, at the same time, giving the portfolio manager the real-data to back up hunches of analyst bias.

Performance Analysis. In the graph below, we show how price forecasts (bars) compare to actual outcomes (underlay). We see that, while Jim Braddock had a disappointingly low success rate (graph above), his price forecasts were excellent. In fact, because the asymmetry was positive, his ideas were net profitable even though only 25% of them made money. From a manager’s perspective, encouraging Jim to make more realistic probability forecasts, gives you data that could dramatically improve fund performance.

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Simple Graphs, Profound Insights. These two simple graphs provide many insights, as illustrated above. A few others to show the power of the picture:

1. Matt Doherty’s names should be given lower confidence given that he only makes money in 50% of his names and he loses more on his losers than he wins on his winners.

2. Ahtray Dahurt’s forecasts should receive higher confidence as his reward and risk price targets and probabilities are in line with actual results.

3. Jim Braddock’s forecasts are net profitable, but his reward probabilities are over inflated. There is an opportunity to profit from his ability to call names with extreme upside returns, but, in the near term, scaling back confidence while working with Jim to improve his batting or at least decrease his forecast probabilities would improve the forecast process.

These are a few of the many insights that Alpha Theory provides to clients to help them become better investment managers. Data provides insights that lead to action that result in an improved process. This chain of improvement is the benefit of capturing and analyzing data. Until we “see the data”, the answer may not be intuitive. This is why it is so important to create a data driven approach, focused on process improvements, that allow you to keep pace with the rapidly evolving data-driven world.