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Alpha Theory Blog - News and Insights

December 1, 2019

Capturing Alpha in Risk Rewards - Morgan Stanley

 

Morgan Stanley has one of the most robust sets of scenario-based price target forecasts in the world with around 70,000 forecasts over 10 years. Naturally, they decided to evaluate the quality of their analysts’ forecasts and the results were positive. In the chart below, their price target, scenario-based strategies consistently created positive alpha.  

 

Screen Shot 2019-11-25 at 2.18.00 PM

 

The model was built by evaluating analysts’ scenario analysis to determine buy and sell signals by using measurements and trends on the variables of Downside, Tilt, and Uncertainty. The magnitude and number of those signals determined the weighting in the hypothetical portfolio.

 

Screen Shot 2019-11-25 at 2.22.41 PM

 

They determined that there was a demonstrable benefit in using a scenario-analysis instead of a single price target.

 

Screen Shot 2019-11-25 at 2.22.56 PM

Screen Shot 2019-11-25 at 2.23.12 PM

 

Breaking the analysis down to its components (individual scenario analyses) showed consistent predictive quality from the scenarios analysis as measured by the pre-cost hit ratio (the percentage of long/short signals that generate higher/lower returns than the total return of the equity index). While a mid-50s hit rate may seem marginal, it is substantial. It is enough to create consistent outperformance, as we measured by observing our managers with consistent hit rates above 50%.

 

Screen Shot 2019-11-25 at 2.46.37 PM

 

The Morgan Stanley analysis is substantive in two ways. First, it supports our research that scenario analyses have predictive power that can be utilized to create positive alpha strategies. The second is our suspicion that buy-side manager scenario analyses are superior to sell-side forecasts because of their real-world application, their lack of administrative constraints, and lack of investment-banking conflict. If that is the case, Alpha Theory forecast dataset should have predictive power superior to that in the Morgan Stanley analysis.

 

This article is one of a long series of “Empirical Proofs” of active manager skill that we’ve been collecting. To see the full list, download a full version of the Concentration Manifesto.

 

November 1, 2019

Concentrating on Concentration: New Data on Portfolio Concentration

 

As most of our readers know, we are proponents of more concentrated portfolios. In May of 2017, we released our Concentration Manifesto which was an attempt to get a critical dialogue started between managers and allocators to ultimately improve the active management process. A conversation that requires both sides cast aside outdated thinking and embraces the notion that concentration is in their best interest.

 

And we’re seeing it in external data:

 

Exhibit 19

 

And in our own managers:

 

AveragePositionSize

 

This conversation began well before our Concentration Manifesto. We recently found an April 2014 study by Cambridge Associates outlining the “Hallmarks of Successful Active Equity Managers.

 

Cambridge Associates analyzed a selection of managers to isolate attributes that lead to success. In their findings, active share and concentration were major contributors. Their analysis1 found that concentrated portfolios (US equity less than 30 positions and US Small-Cap & EAFE Equity less than 40 positions) generated between 100bps and 170bps of additional performance over non-Concentrated portfolios.

 

Table-3.-Results-of-Active-Share-Analysis

 

The performance difference for concentrated managers held after fees and worked across various strategies. The fractal nature (it still works when you break it into different strategies) lends additional validation for concentration’s benefits.

 

In the Cambridge article, we found a reference to another concentration study.

 

Baks, Busse, and Green published “Fund Managers Who Take Big Bets: Skilled or Overconfident” in 2006. The abstract says it all:

 

We document a positive relation between mutual fund performance and managers' willingness to take big bets in a relatively small number of stocks. Focused managers outperform their more broadly diversified counterparts by approximately 30 basis points per month or roughly 4% annualized. The results hold for mimicking portfolios based on fund holdings as well as when returns are measured net of expenses. Concentrated managers outperform precisely because their big bets outperform the top holdings of more diversified funds. The evidence suggests that investors may enhance performance by diversifying across focused managers rather than by investing in highly diversified funds.

 

Their sample covers funds from 1979-2003 and the return advantage per month ranges between +1 and +67 basis points depending on the methodology for measuring fund concentration and how many deciles to included. That equates to a range between +0.12% and +8.34% on an annualized basis for concentrated managers.

 

Fund perf vs. portf weight

 

We continue to believe that there is a demonstrable skill in equity managers and that the skill could be harnessed in better ways than is typically demonstrated by the average manager and that concentration is the simplest way to improve a manager who possesses positive stock-picking skill.

 

1 eVestment Alliance Database: September 2007 to June 2013 US large-cap core equity, US large-cap growth equity, US large-cap value equity, US small-cap core equity, US small-cap growth equity, US small-cap value equity, and all EAFE equity

 

Download full version of the Concentration Manifesto